emerging markets finance - columbia business school...performance of emerging market investments 1....

Emerging markets finance$

Geert Bekaerta,b,*, Campbell R. Harveyb,c

aColumbia University, New York, NY 10027, USAbNational Bureau of Economic Research, Cambridge, MA 02138, USA

cDuke University, Durham, NC 27708, USA

Abstract

Emerging markets have long posed a challenge for finance. Standard models are often ill suited to

deal with the specific circumstances arising in these markets. However, the interest in emerging

markets has provided impetus for both the adaptation of current models to new circumstances in

these markets and the development of new models. The model of market integration and

segmentation is our starting point. Next, we emphasize the distinction between market liberalization

and integration. We explore the financial effects of market integration as well as the impact on the

real economy. We also consider a host of other issues such as contagion, corporate finance, market

microstructure and stock selection in emerging markets. Apart from surveying the literature, this

article contains new results regarding political risk and liberalization, the volatility of capital flows

and the performance of emerging market investments.

D 2002 Elsevier Science B.V. All rights reserved.

Keywords: Market liberalization; Portfolio flows; Market reforms; Economic growth; Risk sharing; Contagion;

Privatization; Capital flows; Market microstructure; Inequality; Productivity; Volatility of capital flows;

Performance of emerging market investments

1. Introduction

In the early 1990s, developing countries regained access to foreign capital after a

decade lost in the aftermath of the debt crisis of the mid-1980’s. Not only did capital flows

to emerging markets increase dramatically, but their composition changed substantially as

0927-5398/02/$ - see front matter D 2002 Elsevier Science B.V. All rights reserved.

PII: S0927 -5398 (02 )00054 -3

$ We have benefited from discussions with Karl Lins and Chris Lundblad. We appreciate the comments of

Stijn Claessens, Vihang Errunza, Kristin Forbes, Andrew Frankel, Eric Ghysels, Angela Ng, Enrico Perotti,

Roberto Rigobon, Frank Warnock. We thank Frank Warnock for providing us with an early release of his U.S.

holdings estimates.

* Corresponding author.

E-mail address: [email protected] (G. Bekaert).

www.elsevier.com/locate/econbase

Journal of Empirical Finance 10 (2003) 3–55

Journal of Empirical FinancePublished in:

COLUMBIA BUSINESS SCHOOL 1COLUMBIA BUSINESS SCHOOL 1

well. Portfolio flows (fixed income and equity) and foreign direct investment replaced

commercial bank debt as the dominant sources of foreign capital. This could not have

happened without these countries embarking on a financial liberalization process, relaxing

restrictions on foreign ownership of assets, and taking other measures to develop their

capital markets, often in tandem with macroeconomic and trade reforms. New capital

markets emerged as a result, and the consequences were dramatic. For example, in 1985,

Mexico’s equity market capitalization was 0.7% of gross domestic product (GDP) and the

market was only accessible by foreigners through the Mexico Fund that traded on the New

York Stock Exchange. In 2000, equity market capitalization had risen to 21.8% of GDP

and U.S. investors alone were holding through a variety of channels about 25% of the

market.1

These developments raise a number of intriguing questions. From the perspective of

investors in developed markets, what are the diversification benefits of investing in these

newly available emerging markets? And from the perspective of the developing countries

themselves, what are the effects of increased foreign capital on domestic financial markets

and ultimately on economic growth?

Market integration is central to both questions. In finance, markets are considered

integrated when assets of identical risk command the same expected return irrespective of

their domicile. In theory, liberalization should bring about emerging market integration

with the global capital market, and its effects on emerging equity markets are then clear.

Foreign investors will bid up the prices of local stocks with diversification potential while

all investors will shun inefficient sectors. Overall, the cost of equity capital should go

down, which in turn may increase investment and ultimately increase economic welfare.

Foreign investment can also have adverse effects, as the 1994 Mexican and 1997 South

Asian crises illustrated. For example, foreign capital flows may complicate monetary

policy, drive up real exchange rates and increase the volatility of local equity markets.

Moreover, in diversifying their portfolios toward emerging markets, rational international

investors should consider that the integration process might lower expected returns and

increase correlations between emerging market and world market returns. To the extent

that the benefits of diversification are severely reduced by the liberalization process, there

may be less of an increase in the original equity price. Ultimately, all of these questions

require empirical answers, which a growing body of research on emerging markets has

attempted to provide.

Of course, it is unlikely that liberalization will lead to the full integration of any

emerging market into the global capital market. After all, the phenomenon of home asset

preference leads many international economists to believe that even developed markets are

not well integrated. In fact, much of the literature has proceeded to compute the benefits of

full market integration in the context of theoretical models of market integration and

international risk sharing. The results of these counterfactual exercises depend very much

on the model assumptions (see Lewis, 1996; Van Wincoop, 1999). The liberalization

process in emerging markets offers an ideal laboratory to test directly some of the

predictions of the market integration and risk sharing theoretical literature.

1 See Thomas and Warnock (2002) for the estimates of U.S. holdings.

G. Bekaert, C.R. Harvey / Journal of Empirical Finance 10 (2003) 3–554

COLUMBIA BUSINESS SCHOOL 2

In this article, we start in Section 2 by focusing on market integration and how it is

related to the liberalization process in emerging markets. We discuss the theoretical

effects of financial market liberalization and the problems in measuring when market

integration has effectively taken place. Section 3 surveys the financial effects of market

integration, from the cost of capital and equity return volatility to diversification bene-

fits.

We also present some new results that examine the volatility of capital flows, the impact

of financial liberalizations on country risk, and the performance of emerging market

investments. Some of these results challenge conventional wisdom. For example, we find

that capital flows to emerging markets as a group are less volatile than capital flows to

developed countries as a group. We also find that despite growing reports on the irrational

behavior of foreign investors in emerging markets, the emerging market portfolios of U.S.

investors outperform a number of natural benchmarks.

Section 4 shifts attention to the real sector. We examine the effects of the li-

beralization process on economic growth, real exchange rates and income inequality. We

present empirical evidence that suggests that for equity market liberalizations, there is a

positive average effect. Nevertheless, a large literature stresses the disastrous effects

freewheeling capital has had through severe currency, equity and banking crises in

Mexico in 1995, Asia in 1997 and Russia in 1998. A comprehensive review of this evi-

dence is beyond the scope of this article; however, in Section 5, we do offer a brief

survey and suggest a somewhat different perspective on the rapidly growing contagion

literature. In Section 6, we briefly review the important aspects of emerging market

finance we do not discuss elsewhere in detail, including corporate finance and gover-

nance issues, the microstructure of emerging equity markets, the emerging fixed income

markets and individual security analysis in emerging markets. Some concluding remarks

are offered in Section 7.

2. Market integration and liberalization

2.1. The theory of market integration

It is important to be clear by what we mean by financial liberalization. In the

development literature, it often refers to domestic financial liberalization (see Gelos and

Werner, 2001; Beim and Calomiris, 2001 for example), which may include banking sector

reforms or even privatizations. By financial liberalization, we mean allowing inward and

outward foreign equity investment. In a liberalized equity market, foreign investors can,

without restriction, purchase or sell domestic securities. In addition, domestic investors can

purchase or sell foreign securities.

There are other forms of financial openness regarding bond market, banking sector and

foreign exchange reforms. The popular International Monetary Fund (IMF) capital account

openness measure lumps all of these together in a 0/1 variable (see below).

Even with our limited focus, the liberalization process is extremely complex and there

is no established economic model that adequately describes the dynamics of the process.

That is, while there are general equilibrium models of economies in integrated states and

G. Bekaert, C.R. Harvey / Journal of Empirical Finance 10 (2003) 3–55 5


segmented states, there is no model that specifies the economic mechanism that moves a

country from segmented to integrated status.2

To gain some intuition, we consider a simple model that traces the impact of market

integration on security prices from the perspective of an emerging market. The model is a

straightforward extension of the standard static integration/segmentation model; (see

Errunza and Losq (1985), Eun and Janakiramanan (1986), Alexander, Eun and Janakir-

amanan and Errunza, Senbet and Hogan (1998), and Martin and Rey (2000)). Within the

context of a simple quadratic utility specification, we examine a three-period problem for

the world market and an emerging market. We assume that there is one share outstanding

of each asset. In period three, dividends are paid out and, hence, there are only two trading

periods. In period two, the government in the developing/emerging country may integrate

the market with the world market or it may not. Each market has a price-taking agent, who

only consumes in the third period. In period one, agents attach a probability, k, to the

government integrating the market with the world market in the second period.

For simplicity, the risk-free rate is set equal to zero and currency considerations are

ignored. Risky assets in the world market (emerging market) yield a random per capita

payoff ofDiW (Di

E) with, i= 1,. . .,NW, (i = 1,. . .,NE) in the third period. Denote the aggregate,

market payoff as DWM ¼ PNW

i¼1DWi and DE

M ¼ PNE

i¼1DEi :

We focus on equity prices in the emerging markets. The second-period prices under

perfect integration or perfect segmentation are well known:

PS2 ¼ E½DE

M� � qVar½DEM�

PI2 ¼ E½DE

M� � qCov½DEM;D

WM �

where q is the risk aversion coefficient and where we assumed the weight of the emerging

market in the global world market to be negligible.

In period 1, agents know that prices in period 2 will either be P2S or P2

I. The attraction of

the quadratic utility framework is that in period 1, the price will be:

P1 ¼ kPI2 þ ð1� kÞPS

2

where k is the probability (in period 1) that the government will integrate the market in

period 2. It is important to realize that P2S <P2

I , since the variability of local cash flows will

be high whereas the covariance between local and world cash flows may be quite low.

Suppose the government announces a liberalization in period 1 to occur in period 2.

The model predicts that prices will jump up and that the size of the jump is related both to

the credibility of the government’s announcement (and policies in general) as captured by

the k parameter, and the diversification benefits to be gained from integrating the market,

as reflected in P1I. Foreign capital flows in when the market finally liberalizes (in period 2)

2 One possibility is to model investments in international markets as being taxed by the host country (Stulz,

1981). A segmented (integrated) country is a country that imposes taxes (no taxes) on incoming and outgoing

investments. A change in regime is a change in the tax rate. For a simple version of this idea, see Bacchetta and

Wincoop (2000). The Errunza and Losq (1985) model, a limiting case of Stulz (1981), also lends itself to an

analysis of a continuum of market structures.



and the price rises again since all uncertainty is resolved. This last price rise may be small

if the announcement was credible.

Fig. 1 presents the implications of this simple model for equity prices and capital flows.

Of course, this model is very stylized and ignores many dynamic effects. This simple

model suggests that variables such as dividend yields and market capitalization to GDP

may change significantly during liberalization as they embed permanent price changes.

This simple story already reveals complex-timing issues. Market prices can change upon

announcement of a liberalization or as soon as investors anticipate, liberalization may

occur in the future. However, foreign ownership can only be established when allowed by

the authorities. That is, capital flows may only occur after the ‘‘return to integration’’ has

Fig. 1. Asset prices and market integration.



already taken place, so that foreign investors may not enjoy this return. (Note that we

assume that capital inflows exceed capital outflows upon liberalization).

The model suggests that expected returns (cost of capital) should decrease. The reason

is that the volatility of emerging market returns is much higher than their covariances with

world market returns. Holding the variances and covariances constant, this implies that

prices should rise (expected returns decrease) when a market moves from a segmented to

an integrated state. However, when a market is opened to international investors, it may

become more sensitive to world events (covariances with the world may increase). Even

with this effect, it is likely that these covariances are still much smaller than the local

variance, which would imply rising prices.

It also makes sense that the liberalization process may be reflected in activity in the

local market. As foreigners are allowed to access the local market, liquidity may increase

along with trading volume.

There could also be some structural changes in the market. For example, if the cost of

capital decreases, new firms may present initial public offerings. Market concentration

may decrease as a result of these new entrants. In addition, individual stocks may become

less sensitive to local information and more sensitive to world events. This may cause the

cross-correlation of individual stocks within a market to change. Morck et al. (2000) find

that stock prices in poor economies move together more (that is, the cross-correlation is

higher) than in rich countries, but they link this phenomenon to the absence of strong

public investor property rights in emerging markets.

The liberalization process is intricately linked with the macro-economy. Liberalization

of markets could coincide with other economic policies directed at inflation, exchange

rates; or the trade sector (see Henry, 2000a for details) and it may be correlated with other

financial reforms aimed at developing the domestic financial system. Liberalization may

also be viewed as a positive step by international bankers that may lead to better country

risk ratings. Hence, these ratings may contain valuable information regarding the

integration process as well as the credibility of reforms.

2.2. Measuring market integration

Once we leave the pristine world of theory, it soon becomes clear that the degree of

market integration is very difficult to measure. Investment restrictions may not be binding,

or there may be indirect ways to access local equity markets for example, through country

funds or American Depositary Receipts (ADRs). For example, the Korea Fund was

launched in 1986, well before the liberalization of the Korean equity market. Also, there

are many kinds of investment barriers, and the liberalization process is typically a complex

and gradual one.

Bekaert (1995) distinguishes between three different kinds of barriers. First are legal

barriers arising from the different legal status of foreign and domestic investors with regard

to, for example, foreign ownership restrictions and taxes on foreign investment. Second

are indirect barriers arising from differences in available information, accounting stand-

ards, and investor protection. Third are barriers arising from emerging market specific

risks (EMSRs) that discourage foreign investment and lead to de facto segmentation.

EMSRs include liquidity risk, political risk, economic policy risk, and perhaps currency



risk. Nishiotis (2002) uses country fund data to examine the differential pricing effects of

these types of barriers and finds indirect barriers and EMSRs to have often more important

pricing effects than direct barriers.

Some might argue that these risks, are in fact, diversifiable and not priced; however,

World Bank surveys of institutional investors in developed markets found that liquidity

problems were seen as major impediments to investing in emerging markets. Moreover,

Bekaert, Erb, Harvey and Viskanta (1997) find political risk to be priced in emerging market

securities. When Bekaert (1995) measures the three types of broadly defined investment

barriers for nine emerging markets, he finds that direct barriers to investment are not

significantly related to a return-based quantitative measure of market integration. However,

indirect barriers, such as poor credit ratings and the lack of a high-quality regulatory and

accounting framework, are strongly related cross-sectionally with the integration measure.

These results reveal the danger in measuring market integration purely by investigating the

market’s regulatory framework. Nevertheless, many researchers have tried this, including

Kim and Singal (2000), Henry (2000a) and Bekaert and Harvey (2000a). Bekaert and

Harvey provide an Internet site with detailed time lines for 45 emerging markets that

provided the basis for the dates in Bekaert and Harvey (2000a).3 Bekaert (1995) and more

recently, Edison andWarnock (2001) have proposed to use the ratio of market capitalization

represented by the International Finance Corporation (IFC) Investable Indices, which

correct for foreign ownership, to the market capitalization represented by the IFC Global

Indices. This ratio has the advantage that it captures gradual liberalizations, as in South

Korea where foreign ownership restrictions were relaxed gradually over time.4

There are a number of potential solutions to the problems posed in trying to date regu-

latory reforms.

First, Bekaert and Harvey (1995) measure the degree of integration directly from equity

return data using a parameterized model of integration versus segmentation (a regime-

switching model). The model yields a time-varying measure of the extent of integration

between 0 and 1. Importantly, the model allows for the possibility of gradual integration,

as in Korea where foreign ownership restrictions were gradually relaxed. In many

countries, with Thailand as a stark example, variation in the integration measure coincides

with capital market reforms. In contrast to general perceptions at the time of this article

was written, its results suggest that some countries became less integrated over time.5

Carrieri et al. (2002) study eight emerging markets over the period 1976–2000. Their

results suggest that although local risk is the most relevant factor in explaining time-

variation in emerging market expected returns, global risk is also conditionally priced for

three countries, while for two countries it exhibits marginal significance. Further, there are

substantial cross-market differences in the degree of integration. More interestingly, they

4 De Jong and De Roon (2002) apply this measure to a model of emerging market expected returns. Bae et al.

(2002a) use the measure to model time-varying volatility.5 The Bekaert and Harvey (1995) model has been extended in Bhattacharya and Daouk (2002), Hardouvelis

et al. (2000), Carrieri et al. (2002) and Adler and Qi (2002). A related model in Bekaert and Harvey (1997) is

extended by Rockinger and Urga (2001).

3 See http://www.duke.edu:80/~charvey/Country_risk/chronology/chronology_index.htm. Also see Bekaert

and Harvey (2000b) and Bekaert, Harvey and Lundbland (2003a).



observe evolution towards more integrated financial markets. This conforms to our a priori

expectations based on the reduction in barriers to portfolio flows, the general liberalization

of capital markets, the increased availability of ADRs and country funds, better infor-

mation and investor awareness. Finally, their results strongly suggest the impropriety of

using correlations of market-wide index returns as a measure of market integration.

Laeven and Perotti (2001) argue that credibility of liberalizations evolves over time.

Their evidence suggests that the positive impact of privatizations occurs during the actual

privatization rather than the announcement period. This is consistent with the importance

of allowing for gradual integration.

Second, Bekaert and Harvey (2000a,b) use bilateral capital flow data in conjunction with

IFC index returns to construct measures of U.S. holdings of the emerging market equities as

a percentage of local market capitalization. The use of more liquid securities represented in

the IFC indices to compute the returns of foreign investors is consistent with Kang and Stulz

(1997) who show that foreign investors in Japan mostly buy large and liquid stocks. Bekaert

and Harvey then determine the time at which capital flows experienced a structural break as

a proxy for when foreign investors may have become marginal investors in these markets.

Although this measure avoids the necessity of having to specify an asset-pricing model and

avoids noisy return data, the capital flow data that they use are complicated by the existence

of financial intermediary centers (e.g. large flows to the UK are channeled to other

countries), and by the fact that the United States is the only country for which we have

detailed data on bilateral monthly flows with emerging markets.6

In Table 1, we show the U.S. holdings measure for various periods for 16 emerging

markets. We contrast its value in the 1980s versus the 1990s and pre- and post-

liberalization, where the liberalization date is the Official Liberalization date from Bekaert

and Harvey (2000a). The message here is simple on average, liberalizations are associated

with increased capital flows. In dollar terms, U.S. holdings increase 10-fold in the 5-years

post-liberalization versus the 5-years pre-liberalization, but in percent of market capital-

ization, the increase is much more modest, but still quite substantial (from 6.2% to 9.4%).

This modest percentage increase is influenced by the steep drop in holdings in the

Philippines, where American capital was substantially present before the official liberal-

ization. Also the dating of the liberalization may be incorrect. Finally the results are

influenced by the fact that, comparing the 1980s to the 1990s, the U.S. share of the IFC

market capitalization increased from 6.6% to 12.9%.

Third, Bekaert, Harvey, and Lumsdaine (2002b) exploit the idea that market integration

is an all-encompassing event that should change the return-generating process, and with it

the stochastic process governing other economic variables. They use a novel methodology

both to detect breaks and to ‘‘date’’ them, looking at a wide set of financial and economic

variables. The resulting break dates are mostly within 2 years of one of four alternative

measures of a liberalization event: a major regulatory reform liberalizing foreign equity

investments; the announcement of the first ADR issue; the first country fund launching;

and a large increase in capital flows.7

6 Also see Warnock and Cleaver (2002), and Tesar and Werner (1995) for an earlier study.7 Garcia and Ghysels (1998) also find strong evidence of structural change when applying different asset

pricing models to emerging markets but they do not ‘‘date’’ the changes.



Finally, the macroeconomic and development literature has mostly focused on a

broader concept of financial or capital market openness, using information in the IMF’s

Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). Within

the AREAER, there is a category called ‘capital account restrictions’, which researchers

have used to mark complete liberalization, that is, when the restrictions go to nil.8

Unfortunately, as Eichengreen (2001) stresses, the IMF measure is an aggregate measure

of many different types of capital controls and may be too coarse. Subcategories have only

become available recently (see Miniane (2000)) and improvements in the measure for

previous years (in particular, see Quinn (1997)) are available only for a few recent years.

3. Financial effects of market integration

There has been an extensive number of articles that measure the effects of the

liberalization process on financial variables. We split the discussion into five parts. The

first part focuses on the equity return generating process: moments of equity returns

(mean, volatility, beta with respect to world returns, etc.). The second part addresses

8 See Mathieson and Rojaz-Suarez (1992) as well as Edwards (1998) and Rodrik (1998).

Table 1

Estimates of U.S. share of MSCI market capitalization around liberalizations

Country U.S. holdings

in millions

U.S. share of

market capitalization

U.S. share of

market capitalization

5-year

pre-liberalization

($)

5-year

post-liberalization

($)

5-year

pre-liberalization

(%)

5-year

post-liberalization

(%)

1980s (%) 1990s (%)

Argentina 193.5 3031.7 20.7 22.5 19.4 28.4

Brazil 243.9 6856.7 1.8 10.3 0.8 14.3

Chile 491.0 3261.8 7.6 10.3 7.1 10.6

Colombia 10.7 191.6 1.2 3.0 1.1 4.1

Greece 4.2 119.3 0.2 2.4 0.5 6.2

India 138.2 2779.1 0.7 5.4 0.6 5.4

Indonesia 46.7 776.0 NA 9.3 14.2 14.5

Jordan NA NA NA NA NA NA

Korea 754.0 6200.6 2.1 6.5 2.0 9.5

Malaysia 225.7 2128.8 1.5 4.7 1.7 8.1

Mexico 1184.5 16,197.8 18.0 26.0 17.0 29.9

Nigeria NA NA NA NA NA NA

Pakistan NA NA NA NA NA NA

Philippines 457.0 2219.1 16.8 12.7 18.8 16.3

Portugal 29.6 219.0 6.3 5.9 5.8 14.2

Taiwan 145.4 746.1 0.2 0.8 0.2 1.8

Thailand 107.3 1000.1 5.5 8.6 6.3 12.9

Turkey 44.4 425.5 3.8 6.3 3.8 13.7

Venezuela 47.5 444.9 6.9 15.2 6.9 16.6

Zimbabwe NA NA NA NA NA NA

Total/average 4123.4 46,597.8 6.2 9.4 6.6 12.9



capital flows, in particular equity flows. The third part focuses on political risk. The fourth

part focuses, diversification benefits. We end this section evaluating the actual investment

performance of U.S. investors in emerging markets.

Before we begin, it is important to realize that our analysis, from a historical

perspective, is based only on the liberalizations that occurred over the last 20 years.

Some emerging markets were thriving markets earlier in the 20th century (e.g. Argentina,

see Taylor, 1998) and re-emerged. Goetzmann and Jorion (1999) study the bias in returns

and betas that re-emergence might cause. For studies of the late 19th century globalization,

see Taylor and Williamson (1994) and Williamson (1996).

3.1. Liberalization and returns

Bekaert and Harvey (2000a) measure how liberalization has affected the equity return-

generating process in 20 emerging markets, focusing primarily on the cost of equity

capital.9 Given the complexity of the liberalization process, they define capital market

liberalization using three alternative measures: official regulatory liberalization, the earliest

date of either an ADR issue, country fund launch, or an official liberalization date, and the

date denoting a structural break in capital flows (leading to increased flows). To measure

the cost of capital, they use dividend yields. The integration process should lead to a

positive return-to-integration (as foreign investors bid up local prices), but to lower post-

liberalization returns. Given high return volatility and considerable uncertainty in timing

equity market liberalization, average returns cannot be used to measure changes in the cost

of capital. Dividend yields capture the permanent price effects of a change in the cost of

capital better than noisy returns.

With a surprising robustness across specifications, they find that dividend yields decline

after liberalizations, but that the effect is always less than 1% on average. The results are

somewhat stronger when they use the liberalization dates from Bekaert, Harvey, and

Lumsdaine (2002b) discussed earlier. Edison and Warnock (2003) find that the decrease in

dividend yields is much sharper for those countries, that experienced more complete

liberalizations. Henry (2000a) finds similar, albeit somewhat stronger, results using a

different methodology and a slightly different sample of countries.

The impact of equity market liberalization on returns is presented in Figs. 2–7. First,

consistent with Bekaert and Harvey (2000a) and Henry (2000a), Fig. 2 shows that average

returns decrease after financial liberalizations. This is consistent with finance theory

depicted in Fig. 1. Also it is possible that the pre-liberalization returns are upwardly biased

from the affects of integration with the world market (the return to integration).10

Consistent with Bekaert and Harvey (1997), Fig. 3 shows that there is no significant

impact on unconditional volatility. Indeed, it is not obvious from finance theory that

volatility should increase or decrease when markets are opened. On the one hand, markets

may become informationally more efficient leading to higher volatility as prices quickly

9 Kawakatsu and Morey (1999) focus on market efficiency. Jain-Chandra (2002) examines efficiency after

liberalizations.10 See also Errunza (2001) who shows that there is significant growth in market capitalization divided by

GDP, trading volume divided by GDP, the turnover ratio and the number of listings after liberalization.



react to relevant information or hot speculative capital may induce excess volatility. On the

other hand, in the pre-liberalized market, there may be large swings from fundamental

values leading to higher volatility. In the long run, the gradual development and

diversification of the market should lead to lower volatility.11

Bekaert and Harvey (2000a) argue that correlation and beta with the world market

increase after equity market liberalizations. Figs. 4 and 5 show that unconditional

correlations and betas both increase after liberalization. Indeed, of the 20 countries, only

3 countries experience a decrease in their correlations and betas—and the decrease is

small. Figs. 6 and 7 present the time-series of rolling unconditional correlations and betas.

Around the time of a clustering of equity market liberalizations in the late 1980s and early

1990s, both the average correlations and betas with the world increase. There is an even

larger increase at the end of the 1990s, which may reflect further integration and overall

higher market volatility (see Section 5), or the increase may be temporary, brought about

by a potential bubble in global technology stocks (see Brooks and Del Negro, 2002).

These results are corroborated in a recent study by Carrieri et al. (2002).

The analysis in Figs. 2–7 is unconditional. That is, we look at simple averages before

and after liberalization. However, this type of analysis does not control for other financial

and economic events that may coincide with equity market liberalization. Bekaert and

Harvey (2000a) estimate panel regressions with a set of variables that are designed to

control for coincidental financial and economic events. Interestingly, the message is

similar to the unconditional analysis after liberalizations, expected returns decrease

correlations and betas increase, and there is no particular impact on volatility.

Fig. 2. Average annual geometric returns. Pre and post Bekaert–Harvey Official Liberalization dates.

11 See also Richards (1996), De Santis and Imrohoroglu (1997), Aggarwal et al. (1999) and Kim and Singal

(2000) for studies of the effects of liberalization on stock market volatility.



There exists interesting corroborating evidence from the firm-level price effects of

ADRs. An ADR from a country with investment restrictions can be viewed as investment

liberalization. For example, when Chile had repatriation restrictions in place, it had to lift

them for companies listing their shares overseas to make cross-market arbitrage possible.

When the ADR is announced, we expect positive abnormal returns and presumably ex-

Fig. 4. Correlation with world. Pre and post Bekaert–Harvey Official Liberalization dates.

Fig. 3. Average annualized standard deviation. Pre and post Bekaert–Harvey Official Liberalization dates.



post under performance indicating lower expected returns after the liberalization. Of

course, benchmarking ADR firms may be difficult, especially because the local market

may experience significant spillover effects (see Urias, 1994). Overall, these predictions

are borne out by the data and the announcement effect of ADR issuance is significant,

being typically larger than 1% (see Miller, 1999; Foerster and Karolyi, 1999). Using a

sample of 126 ADRs from 32 countries, Errunza and Miller (2000) document a very

Fig. 6. Evolution of world correlation. Five-year rolling window: 20 countries.

Fig. 5. Beta with world. Pre and post Bekaert–Harvey Official Liberalization dates.



significant decline in the cost of capital. In addition, they show that the decline is driven by

the inability of U.S. investors to span the foreign security with domestic securities prior to

cross-listing. Of course, there are many reasons, apart from liberalization, why ADR issues

may induce a positive price effect, including additional liquidity and, the relaxation of

capital constraints (Lins et al., 2001 for example). For further details, we refer to the

excellent survey by Karolyi (1998). Recent studies by Chari and Henry (2001) and Patro

and Wald (2002) also generally confirm the liberalization effects documented above using

firm-specific data.

3.2. Liberalization and capital flows

With the emerging markets crises in the second half of the 1990s, the role of foreign

capital in developing countries once again came under intense scrutiny. One country,

Malaysia, imposed severe capital controls on October 1, 1998, in an effort to thwart the

perceived destabilizing actions of foreign speculators. After a decade of capital market

liberalizations and increased portfolio flows into developing countries, the process seemed

to stall or even reverse. It is, therefore, important to develop an understanding of the

dynamics, causes and consequences of capital flows in emerging markets. In particular, we

need to understand the role of financial liberalization in these dynamics.

There is a growing body of research that studies the joint dynamics of capital flows and

equity returns (see, for example, Warther, 1995; Choe et al., 1999; Froot et al., 2001; Clark

and Berko, 1997; Edelen and Warner, 2001; Stulz, 1999; Edison and Warnock, 2001;

Richards, 2002; Griffin et al., 2002). The first hypothesis of interest is whether foreign

investors are ‘‘return chasers,’’ in the terms of Bohn and Tesar (1996), that is, are flows

caused by changes in expected returns? A related hypothesis is that international investors

are momentum investors, leading to a positive relation between past returns and flows. A

second set of hypotheses focuses on the effect of flows on returns. Both Froot et al. (2001)

Fig. 7. Evolution of world beta risk. Five-year rolling window: 20 countries.



(focusing on 28 emerging markets) and Clark and Berko (focusing on Mexico) find that

increases in capital flows raise stock market prices, but the studies disagree on whether the

effect is temporary or permanent. If the increase in prices is temporary, it may be just a

reflection of ‘‘price pressure,’’ which has also been documented in developed markets for

mutual fund flows and stock indices (Warther, 1995; Shleifer, 1986). If the price increase

is permanent, it may reflect a long-lasting decrease in the cost of equity capital associated

with the risk-sharing benefits of capital market openings in emerging markets.

When focusing on emerging markets, the structural changes associated with capital

market liberalization complicate any empirical analysis of capital flows, since these

changes can cause permanent or at least long-lasting changes in the data-generating

processes. Bekaert, Harvey and Lumsdaine (2002a) investigate the joint dynamics of

returns and net U.S. equity flows acknowledging the important effects capital market

liberalization may have. They precede their analysis with a detailed endogenous break-

point analysis that helps define the relevant time-period over which to conduct the

analysis. In general, they find sharply different results if their models are estimated over

the entire sample—which ignores a fundamental nonstationarity in the data—versus a

post-break (liberalization) sample. They find that net capital flows to emerging markets

increase rapidly after liberalization as investors rebalance their portfolios, but that they

level out after 3 years. As Fig. 1 indicates, if capital market liberalizations induce one-time

portfolio rebalancing on the part of global investors, one may expect net flows to increase

substantially after a liberalization and then to decrease again (see Bacchetta and Wincoop,

2000 for a formal model generating such dynamics). The empirical pattern appears

consistent with this conclusion.

Furthermore, Bekaert, Harvey and Lumsdaine (2002a) add two variables to the

bivariate vector autoregression set-up of returns and equity flows in Froot et al. (2001):

the world interest rate and local dividend yields. The low level of U.S. interest rates has

often been cited as one of the major reasons for increased capital flows to emerging

markets in 1993 (see World Bank, 1997 as well as Calvo et al., 1993, 1994; Fernandez-

Arias, 1996). However, Bekaert, Harvey and Lumsdaine (2002a) do not find a significant

effect on capital flows to emerging markets from an unexpected reduction in world interest

rates.

Other main findings include that unexpected equity flows are indeed associated with

strong short-lived increases in returns. However, they also find that they lead to permanent

reductions in dividend yields, which may reflect a change in the cost of capital. Hence, the

reduction in the dividend yield suggests that additional flows reduce the cost of capital,

and that the actual return effect is not a pure price pressure effect because it is partially

permanent.

In more recent work, the focus has shifted towards detailed studies of the trading

behavior of foreign investors in an effort to detect herding behavior and other behavioral

biases. Two such studies, focusing on Korea before and during the currency crisis in 1997,

are Choe et al. (1999) and Kim and Wei (2002a). Choe et al. find evidence of positive

feedback trading and herding by foreign investors before the crisis, but not during the

crisis period. They find no evidence that trades by foreign investors had a destabilizing

effect on Korea’s stock market and found the market to adjust quickly and efficiently to

large sales by foreign investors. Kim and Wei find that foreign investors outside Korea are



more likely to engage in positive feedback trading strategies and in herding than the

branches and subsidiaries of foreign institutions in Korea or foreign individuals living in

Korea. This difference in trading behavior is possibly related to the difference in possessed

information by the two types of investors.

One problem that such studies face is that it is quite difficult to distinguish between

irrational and rational trading in a country that is still liberalizing has stocks trading with

and without associated ADRs, and is hit with an enormous economic crisis. Another

problem is that however detailed the data; some foreign transactions are bound to be

undetected and may undermine testing behavioral hypotheses. For example, hedge funds

may hold Korean equity exposure through an asset swap with a local company, which will

not be detected by the usual capital flow statistics. Apart from trades executed through

derivatives, 1998 was also a very active ADR issue year for Korea, again making the

determination of net positions difficult. Of course, such problems also complicate the

interpretation of the more aggregate studies discussed earlier.

There is another related and rapidly growing literature that investigates the behavior of

mutual funds investing in emerging markets. These include Borensztein and Gelos (2001),

Kim and Wei (2002b), and Frankel and Schmukler (2000). Given that there already exists

a survey article on this topic (Kaminsky et al., 2001), we do not further discuss these

articles further.

Much has been made about the increased volatility of capital flows post liberalization

(see Stiglitz, 2000). This discussion strikes us, in many ways, as odd. The emerging

countries start with little or no capital flows and move to an environment (post liberaliza-

tion) with significant capital flows which are, as expected, subject to portfolio rebalancing.

Consequently, it is no mystery that the volatility of capital flows increases. In fact, if we

revisit Fig. 1, the segmentation model predicts that volatility should spike around the time of

market liberalization, but should then subside once the large capital inflow has occurred. Of

course, there is always the worry that portfolio flows are not as ‘‘sticky’’ as foreign direct

investment (FDI) and may disappear at a whim causing a crisis in the process (see Claessens

et al., 1995) for an attempt to distinguish between hot and other forms of capital).

In Fig. 8, we provide a very simple measure of the evolution of capital flow volatility

over time. We computed the coefficient of variation (volatility over mean) of the U.S.

holdings measure previously referenced above for 16 emerging countries. Fig. 8 graphs the

3-year rolling window coefficient of variation for the aggregate U.S. holdings in these

markets over time. Note that, the volatility measure starts to increase sharply in the early

1990s when many liberalizations take place and continues to increase, reaching its peak in

1995 at the time of the Mexican peso crisis. After falling sharply the volatility measure

reaches another, but much lower peak at the end of 1997 around the time of the Asian

crisis. Interestingly, 2000 was also a rather volatile year, but volatility in 2001 fell back to

levels observed in the very early 1990s. It is very difficult to establish whether this

volatility is excessive. Indeed, for comparison, we also consider the 3-year coefficient of

variation of U.S. holdings in developed markets.12 There is an even more substantial

12 The set of developed countries follows Harvey (1991). We omit Hong Kong and Singapore/Malaysia from

the set of MSCI developed markets. We also omit New Zealand because of lack of holdings data.



increase in the mid- to late-1990s in capital flows volatility for developed markets. In fact,

both measures show similar patterns and capital flows to developed countries were more

volatile than flows to emerging markets.

3.3. Liberalization and political risk

What is the relation between equity market liberalizations and political risk? Bekaert

and Harvey (2000a) present some evidence that country ratings significantly increase

(lower risk) with one of their measures of equity market liberalization. This is important

because Erb et al. (1996a,b) show a significant cross-sectional relation between country

rating and future equity returns and Bekaert Erb, Harvey and Viscanta (1997) make the

case that political risk is a priced risk in emerging markets. That is, increased ratings lead

to lower costs of capital.

Table 2 summarizes the behavior around liberalizations in 20 emerging markets studied

in Bekaert and Harvey (2000a) with respect to the International Country Risk Guide’s

(ICRG’s) measures of political, economic, and financial risk ratings. We report the rating

at time t, which is the month of the official liberalization, reported in Bekaert and Harvey.

We also report 1 year earlier, t� 1, as well as 1 and 2 years after the liberalization t + 1, and

t + 2. The results are striking. The ICRG measure of political risk rating increases by

10.8% from t� 1 to t+ 2 (indicating lower political risk). During this same period, the

largest change is with the financial risk rating measure, which increases by 26.8%, while

the composite risk rating measure, which combines the three components, increases by

15.8%. This evidence is consistent with political risk and the cost of capital decreasing

after equity market liberalizations. One market measure of political risk is the yield spread

on dollar-denominated emerging market bonds, relative to dollar yields. Adler and Qi

(2002) study market integration between the U.S. and Mexico using Brady bond spreads

as an indicator of effective market integration and find that the spread significantly affects

Fig. 8. Three-year rolling coefficient of variation of U.S. emerging and developed market equity holdings.



Table 2

Equity market liberalization and political risk

(A) Political risk t� 1 t t + 1 t + 2 (B) Financial risk t� 1 t t + 1 t + 2

Argentina 56.0 61.0 64.0 66.0 Argentina 19.0 20.0 23.0 31.0

Brazil 69.0 64.0 69.0 66.0 Brazil 28.0 33.0 37.0 35.0

Chile 64.0 66.0 67.0 69.0 Chile 40.0 42.0 42.0 43.0

Colombia 54.0 59.0 61.0 58.0 Colombia 28.0 37.0 41.0 41.0

Greece 58.0 63.0 62.0 61.0 Greece 26.0 31.0 30.0 30.0

India 43.0 51.0 62.0 65.0 India 29.0 35.0 36.0 36.0

Indonesia 39.0 41.0 51.0 57.0 Indonesia 18.0 28.0 41.0 44.0

Jordan 73.0 76.0 70.0 73.0 Jordan 35.0 37.0 38.0 38.0

Korea 64.0 75.0 75.0 75.0 Korea 47.0 47.0 47.0 47.0

Malaysia 62.0 58.0 59.0 70.0 Malaysia 26.0 31.0 38.0 45.0

Mexico 69.0 68.0 70.0 71.0 Mexico 28.0 29.0 32.0 38.0

Nigeria 53.0 53.0 53.0 45.0 Nigeria 27.0 26.0 24.0 28.0

Pakistan 33.0 27.0 34.0 40.0 Pakistan 22.0 17.0 28.0 30.0

Philippines 37.0 41.0 44.0 55.0 Philippines 24.0 22.0 27.0 34.0

Portugal 70.0 71.0 67.0 76.0 Portugal 35.0 38.0 37.0 43.0

Taiwan 75.0 71.0 76.0 77.0 Taiwan 49.0 49.0 49.0 48.0

Thailand 54.0 55.0 60.0 59.0 Thailand 29.0 29.0 36.0 40.0

Turkey 48.0 45.0 45.0 52.0 Turkey 23.0 20.0 20.0 19.0

Venezuela 69.0 65.0 74.0 75.0 Venezuela 29.0 27.0 39.0 40.0

Zimbabwe 63.0 66.0 66.0 67.0 Zimbabwe 24.0 30.0 30.0 33.0

Average 57.7 58.8 61.5 63.9 Average 29.3 31.4 34.8 37.2

Increase from t� 1 2.0% 6.6% 10.8% Increase from t� 1 7.2% 18.6% 26.8%

(C) Economic risk t� 1 t t + 1 t + 2 (D) Composite risk t� 1 t t + 1 t + 2

Argentina 18.0 14.0 25.5 24.5 Argentina 48.0 47.5 56.5 61.5

Brazil 20.0 23.5 26.5 25.0 Brazil 58.5 60.0 66.5 63.0

Chile 30.5 32.0 38.0 39.0 Chile 67.5 70.0 73.5 75.5

Colombia 29.5 34.0 35.0 38.0 Colombia 56.0 65.0 68.5 68.5

Greece 28.5 31.0 29.5 32.5 Greece 56.5 62.5 61.0 62.0

India 26.0 28.5 31.5 35.5 India 49.0 57.5 65.0 68.5

Indonesia 33.5 34.5 35.0 36.0 Indonesia 45.5 52.0 63.5 68.5

Jordan 38.5 38.0 38.0 39.5 Jordan 73.5 75.5 73.0 75.3

Korea 37.0 36.5 40.0 41.0 Korea 74.0 79.5 81.0 81.5

Malaysia 37.5 41.0 39.0 40.0 Malaysia 63.0 65.0 68.0 77.5

Mexico 27.5 27.5 25.5 29.0 Mexico 62.5 62.5 64.0 69.0

Nigeria 26.0 26.0 23.0 29.0 Nigeria 53.0 52.5 50.0 51.0

Pakistan 31.5 32.0 31.5 31.5 Pakistan 43.5 38.0 47.0 51.0

Philippines 29.5 29.0 31.0 34.0 Philippines 45.5 46.0 51.0 61.5

Portugal 34.0 34.5 36.0 38.0 Portugal 69.5 72.0 70.0 78.5

Taiwan 42.5 43.0 43.0 44.5 Taiwan 83.5 81.5 84.0 85.0

Thailand 33.0 36.5 35.5 36.0 Thailand 58.0 60.5 66.0 67.5

Turkey 26.0 28.0 28.0 27.5 Turkey 48.5 46.5 46.5 49.5

Venezuela 25.0 27.0 32.5 35.5 Venezuela 61.0 59.5 73.0 75.5

Zimbabwe 22.5 25.0 29.0 32.5 Zimbabwe 55.0 60.5 62.5 66.5

Average 29.8 31.1 32.7 34.4 Average 58.6 60.7 64.5 67.8

Increase from t� 1 4.2% 9.5% 15.4% Increase from t� 1 3.6% 10.2% 15.8%

All ratings from International Country Risk Guide. 100 =maximum; 0 =minimum. t =Official Liberalization date

from Bekaert and Harvey (2000a,b). We also report the ratings 1 year before as well as 1 and 2 years after the

Official Liberalization.



expected returns. Country risk measures may reflect the credibility of the government’s

market-oriented reforms and its commitment to open capital markets. Perotti and van Oijen

(2001) show that privatizations (see below) are significantly associated with lower

political risk over time. Perotti (1995) presents the theoretical framework that links

credible privatization and political risk.

3.4. Liberalization and diversification benefits

Although emerging market equity returns are highly volatile, they are relatively less

correlated with equity returns in the developed world, making it possible to construct low-

risk portfolios. Whereas the pioneering study of Errunza (1977) was largely ignored by

both the academic and practitioner communities, interest in emerging market investments

re-surfaced in the early 1990s. Early studies show very significant diversification benefits

for emerging market investments, (Divecha et al., 1992; De Santis, 1993; Harvey, 1995).

However, these studies used market indexes compiled by the (IFC) that generally ignore

the high transaction costs, low liquidity, and investment constraints associated with

emerging market investments.

Bekaert and Urias (1996, 1999) measure the diversification benefits from emerging

equity markets using data on closed-end funds (country and regional funds), and

(ADRs).13 Unlike the IFC indexes, these assets are easily accessible to retail investors,

and transaction costs are comparable to those for U.S.-traded stocks. The distinguishing

feature of closed-end funds is that fund share prices generally deviate from the market

value of all securities in the portfolio (known as ‘‘net asset value’’); they may trade at a

premium when the assets are invested in closed or restricted markets, or at a discount when

the foreign market has unusual political risk. Historically, they provided access to

restricted markets, while open-end funds and ADRs were relatively unimportant before

1993.

Bekaert and Urias (1996, 1999) generally find that investors give up a substantial part

of the diversification benefits of investing in foreign markets when they do so by holding

closed-end funds. Other studies, such as Bailey and Stulz (1990), Bailey and Lim (1992)

and Chang et al. (1995) found larger diversification benefits but had not taken small

sample biases in the statistical tests into account. Open-end funds, on the other hand, track

the underlying IFC indices much better than other investment vehicles and prove to be the

best diversification instrument in the Bekaert and Urias sample.

De Roon et al. (2001) and Li et al. (2003) take the transactions costs that investors in

emerging markets face directly into account when measuring diversification benefits. De

Roon et al. find that the diversification benefits of investing in emerging markets are

eliminated when transactions costs and, in particular, short-sale constraints are introduced.

However, they admit that there is some evidence of bias in their asymptotic spanning

analysis. Unlike the asymptotic mean variance tests, Li et al. use a Bayesian approach, that

incorporates the uncertainty of finite samples into their analysis. They argue that the

diversification benefits to investing in emerging markets remain substantial even in the

13 Also see Diwan et al. (1995).



presence of short-sale constraints. These two articles use the IFC indices to test for

diversification benefits. Errunza et al. (1999) show that most of these diversification

benefits can be obtained using domestically traded assets (ADRs and country funds).

By removing price segmentation, liberalizations may increase correlations and hence

reduce diversification benefits. Using a model in which conditional correlations depend on

world volatility and variables tracking the degree of integration, Bekaert and Harvey

(1997) measure the time-variation in correlations for 17 emerging markets. For some

countries, for example, Thailand, correlations increase markedly around the time of

liberalization. The average response of these conditional correlations to liberalizations

in 17 emerging markets is a small but statistically significant increase of 0.08 at most.

3.5. How well have emerging market portfolios done?

As we outlined before, there is some discussion in the literature suggesting that those

who invest in emerging markets are subject to herding and other irrational behavior. Rather

than focusing on one emerging market, we carry out two simple exercises to assess the

overall performance of portfolio investment in emerging markets.

Our first exercise examines the performance of actual portfolio investments by U.S.

investors in emerging countries. That is, the definition of U.S. investor is comprehensive,

including all U.S. investments covered by the aggregate equity flow statistics, in contrast

to studies such as Froot et al. (2001), who only focus on institutional investors. We

compare their actual emerging market holdings through time to both an equally weighted

and a value-weighted benchmark investment strategy as well as to the IFC Composite

return. The difference between the U.S. portfolio weights and the benchmark investment

weights represents U.S. investors ‘over’ or ‘under’ weighting in these markets. We

compute these weights using the accumulated capital flow data from the U.S. Treasury

and from Warnock and Cleaver (2002).

The results in Table 3 suggest that U.S. investors’ country allocation led to substantially

higher returns than all three benchmarks. For example, in the 1990s, the U.S. portfolio

return was 11.4% compared to only 4.4% for the value-weighted benchmark of the 16

countries where we have U.S. holdings.14 It is unlikely that this out performance would be

overturned if additional countries were considered. During this period, the broader IFC

Composite index returned only 0.1% on average.

The second exercise looks at aggregate investment in emerging markets versus

developed markets. We conduct the following experiment. Using holdings data for both

developed and emerging markets, we calculate the total U.S. foreign holdings. We

determine the proportion of U.S. holdings in emerging markets versus developed markets

(not including the U.S.). Using the same countries for which we have holdings data, we

then calculate market capitalization weighted indices for both emerging and developed

markets. Again, we can determine the proportion of total capitalization in emerging and

developed markets.

14 Holdings data are not available for Jordan, Nigeria and Zimbabwe. The revised data from Warnock and

Cleaver (2002) also do not include data for Pakistan.



The results are in Table 4. The first two columns provide summary statistics for the U.S.

holdings weight times both value and equally weighted developed and emerging market

indices. That is, the portfolio mimics the actual allocation between emerging and

developed markets but uses market indices within these broad groups. In the next two

columns, we replace the holdings weights with market capitalization weights. The

difference in performance is due to the difference in U.S. allocation to emerging markets

relative to developed markets—rather than any particular country selection. That is, the

weights, whether holdings-based or capitalization-based are multiplied by the same return

indices. The results suggest that there is not much difference between the capitalization

weights and the holdings weights in terms of the returns. For example, since 1990, the

returns to the holdings-based weights and the market capitalization weights are both 4.4%

per annum. The volatility is also very similar. Interestingly, even a fixed 90% weight in

developed markets and 10% weight in emerging markets (see the last column) produces

similar results. Hence, the overall U.S. allocation performance is quite similar to the

performance that would have obtained from market capitalization weighting.

While the previous exercise is necessary for comparison, the analysis does not fairly

represent the U.S. investor performance. We use the holdings to determine the aggregate

weights in developed and emerging markets and then allocate to passive market capital-

ization benchmarks for these two groups of markets (that is, we ignore the country

selection). But the results in Table 3 have already demonstrated some ability to choose the

right countries. The fifth column of Table 4 allows for country selection. We use the

weights in developed and emerging markets and create a developed and emerging market

benchmark that reflects the country weighting chosen by U.S. investors. Consistent with

the emerging market analysis, U.S. investors substantially outperform the market capital-

ization benchmark. For example, from 1990, the U.S. return is 7.6% per annum compared

to a value-weighted benchmark return of 4.4%. The volatility of the U.S. strategy is 130

basis points lower than the volatility of the value weighted benchmark. Indeed, the U.S.

Table 3

Performance of U.S. investments in emerging equity markets

IFC

composite

(%)

Value-weighted

IFC 16

countries (%)

Equally

weighted IFC 16

countries (%)

U.S. country

allocation

performance (%)

Mean from 1977 12.0 9.1 17.3

Std. dev. from 1977 22.6 19.2 25.9

Mean from 1981 11.2 7.0 14.2

Std. dev. from 1981 23.8 20.1 27.0

Mean from 1985 8.3 14.2 11.6 21.8

Std. dev. from 1985 23.9 25.2 21.1 28.0

Mean from 1990 0.1 4.4 2.6 11.4

Std. dev. from 1990 23.1 24.6 22.1 26.0

Data through December 2001. Mean represents the average compound return which is annualized in percent. Std.

dev. is the annualized standard deviation in percent. The 16 country portfolios exclude: Jordan, Nigeria, Pakistan

and Zimbabwe where holdings estimates are not available.



Table 4

Performance of U.S. investment in developed and emerging equity markets

EM/Developed

holdings weights

times market

cap weighted

country indices (%)

EM/Developed

holdings weights

times equally

weighted

country indices (%)

EM/Developed

market cap weights

times market

cap weighted

country indices (%)

EM/Developed

market cap

weights times

equally weighted

country indices (%)

EM/Developed

holdings

weights times

holdings weighted

country indices (%)

MSCI world

composite (%)

10% EM 90%

Developed (%)

Mean from 1977 13.0 12.1 13.1 12.1 14.4 12.2 12.9

Std. dev. from 1977 16.0 14.7 16.1 14.9 15.4 14.1 15.8

Mean from 1981 11.7 11.5 11.9 11.6 12.5 11.9 11.7

Std. dev. from 1981 16.7 15.3 16.7 15.2 15.7 14.5 16.5

Mean from 1985 12.8 13.6 12.8 13.7 14.3 12.7 12.8

Std. dev. from 1985 17.1 15.8 17.0 15.7 15.8 14.9 16.9

Mean from 1990 4.4 6.7 4.4 6.8 7.6 7.5 4.3

Std. dev. from 1990 16.5 15.0 16.4 14.9 15.1 14.5 16.5

Data through December 2001. Mean represents the average compound return which is annualized in percent. Std. dev. is the annualized standard deviation in percent.

G.Beka

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global return is even higher than the MSCI world market composite return—which

includes a substantial weight for U.S. equity (which we know has done well over the past

12 years). All in all, the overall investment performance of U.S. investors is much rosier

than the country-by-country results, which focus on behavioral biases. Disyatat and Gelos

(2001) study the asset allocation of emerging market funds and find that it is not

inconsistent with mean-variance optimizing behavior. Their results are similar in spirit

to ours. However, Frankel and Schmukler’s (2000) study on country funds suggests that

the holders of the underlying assets (the portfolio managers) have more information than

the country fund holders (the investors).

4. Real effects of financial market integration

From 1980 to 1997, Chile experienced average real GDP growth of 3.8% per year

while the Ivory Coast had negative real growth of 2.4% per year. Why? Attempts to

explain differences in economic growth across countries have again taken center stage in

the macroeconomic literature. Although there is no agreement on what determines

economic growth, most of the literature finds evidence of conditional convergence. Poorer

countries grow faster than rich countries, once it is taken into account that poor countries

tend to have lower long-run per capita GDPs, for example, because of the poor quality of

their capital stock (both physical and human). Sachs and Warner (1995) have argued that

policy choices, such as respect for property rights and open international trade, are

important determinants of the long-run capacity for growth. Williamson (1996) has already

argued that fast growth, globalization and convergence are positively correlated from the

historical perspective of the end of the 19th century until now. Here, we focus on the real

effects of the most recent wave of liberalizations.

There are some interesting differences between the two countries we mentioned. First,

the Ivory Coast has a larger trade sector than Chile, but the role of trade openness remains

hotly debated. Second, Chile liberalized its capital markets, in particular its equity market,

to foreign investment in 1992. After the liberalization, the Chilean economy grew by 6.3%

per year.

4.1. Why would financial liberalization affect economic growth?

There are a number of channels through which financial liberalization may affect

growth. First, foreign investors, enjoying improved benefits of diversification, will drive

up local equity prices permanently, thereby reducing the cost of equity capital. Con-

sequently, the real variable most sensitive to the cost of capital should be real investment.

Bekaert and Harvey (2000a), Bekaert, Harvey and Lundblad (2002c), and Henry (2000b)

all find that investment increases post equity market liberalization. If this additional

investment is efficient, then economic growth should increase. However, in the aftermath

of the recent crises, some economists feel that foreign capital has been wasted on frivolous

consumption and inefficient investment, undermining the benefits of financial liberaliza-

tion. Bekaert, Harvey and Lundblad (2002c) show that not only does the ratio of

investment to GDP actually increases, but also that the ratio of consumption to GDP



does not increase after liberalization. The additional investment appears to be financed by

foreign capital as the trade balance significantly decreases.

Second, there is now a large literature on how more developed financial markets and

intermediation can enhance growth and how well-functioning equity markets may promote

financial development [see, for example, Levine (1991); King and Levine (1993); Levine

and Zervos (1996, 1998a,b); Levine et al. (2000)]. Furthermore, foreign investors may also

demand better corporate governance to protect their investments, reducing the wedge

between the costs of external and internal financial capital, and further increasing

investment. There is, in fact, a large and growing literature on how the relaxation of

financing constraints improves the allocation of capital and promotes growth [(see Rajan

and Zingales (1998); Love [in press]; Wurgler (2000)). Lins et al. (2001)] show that firms

in emerging markets listing on the U.S. exchanges are able to relax financing constraints.

Since ADRs can be viewed as firm-specific investment liberalizations, this research

directly establishes a link between liberalization and financing constraints. Galindo et al.

(2001) show that financial liberalization improves the efficiency of capital allocation for

individual firms in 12 developing countries. Laeven (2001) has examined the role of

banking liberalization in relaxing financing constraints for emerging markets. Forbes

(2002) finds that Chilean capital controls significantly increased financial constraints for

smaller firms. The interplay between economic growth, financial development and

corporate finance is likely to be an important area for future research, and is a topic to

which we return to in Section 5.

4.2. Measuring the liberalization effect on economic growth

Bekaert, Harvey and Lundblad (2001) propose a time series panel methodology that

fully exploits all the available data to measure how much an equity market liberalization

increases growth. They regress future growth (in logarithmic form), averaged over periods

ranging from 3 to 7 years, on a number of predetermined determinants of long-run steady

state per capita GDP, including secondary school enrollment, the size of the government

sector, inflation, trade openness, and on initial GDP (measured in logarithms) in 1980. The

right-hand side variables also include an indicator of liberalization based primarily on an

analysis of regulatory reforms in Bekaert and Harvey (2000a). To maximize the time-series

content in their regressions, they use overlapping data. For example, they use growth from

1981 to 1986 and from 1982 to 1987 in the same regression. They correct for the resulting

correlation in the model’s residuals in the standard errors. Estimating the model by the

Generalized Method of Moments, they can also adjust for the correlation of residuals

across countries and different variances of residuals both across countries and over time

(heteroskedasticity).

Bekaert, Harvey and Lundblad (2001) consider the liberalization effect in a small

sample of 30 emerging and frontier markets as defined by the IFC and found that

economic growth increased by 0.7% to 1.4% per year post liberalization.

Bekaert, Harvey and Lundblad (2002c) expand the sample to 95 countries, including to

countries that may not even have financial markets, as well as to developed countries. The

liberalization effect now has a cross-sectional component that measures the difference in

growth between segmented and financially open countries, as well as a temporal



component (countries before and after liberalization). It is this cross-sectional dimension

that has been the main focus of the trade openness literature.

Expanding the sample of countries strengthens the results. Taken by itself, financial

liberalization leads to an increase in average annual per capita GDP growth of 1.5 to

2.3 percent per year. When they factor in a host of other variables that might also boost

economic performance, improvements associated with financial liberalization still

remain strong, 0.7% to 1.4% per year. In examining a number of different samples

(whose size depends on the availability of control variables), the financial liberalization

effect seems robust. They also consider an alternative set of liberalization dates. The

main results are robust to these alternative dates. Further, they carry out a Monte Carlo

experiment whereby one country’s liberalization date is assigned randomly to another

country. This allows them to test whether these results primarily reflect overall

economic growth in the late 1980s and early 1990s (when the liberalization dates are

concentrated). The Monte Carlo exercise shows that the liberalization dates do not

really explain economic growth when they are decoupled from the specific country to

which they apply, showing that the effect is not related to the world business cycle

during these years.

4.3. Intensity and simultaneity problems in measuring real liberalization effects

4.3.1. Intensity of the reforms

There is a heated debate about the effect of capital account openness on economic

growth and economic welfare, especially in developing countries [see, for example,

Rodrik (1998); Edwards (2001); Arteta et al. (2001). Eichengreen (2001)] suggests that the

weak and inconsistent results might be due to the fact that the IMF’s AREAER was used

as a measure of capital account restrictions. Because this measure does not differentiate

between capital account restrictions, it is too coarse to yield meaningful results. When

capital account restrictions are more finely measured, as in Quinn (1997), Quinn et al.

(2001), and Edwards (2001), there does appear to be a growth effect, although it is fragile

(see Arteta et al., 2001). Bekaert, Harvey and Lundblad (2001, 2002c), focusing on equity

liberalization only, find a robust growth effect. Moreover, they also employ a measure that

captures the intensity of the liberalization by taking the ratio of the market capitalization of

the IFCs investable index versus the IFCs global index (see also Bekaert, 1995; Edison

and Warnock, 2003) or the number of investable securities compared to the total number

of securities. These measures also point to a strong positive growth effect from

liberalization.

4.3.2. Financial liberalization and macroeconomic reforms

It is possible that financial liberalizations typically coincide with other more macro-

oriented reforms which are the source of increased growth and not the financial

liberalizations. However, when Bekaert, Harvey and Lundblad (2002c) add variables

capturing macroeconomic reforms, such as inflation, trade openness, fiscal deficits and the

black market premium, the liberalization effect remains intact. In some specifications, it

does weaken somewhat suggesting that macroeconomic reforms may, indeed, account for

some of the liberalization effect.



4.3.3. Financial liberalization and financial market development

Another possibility is that financial liberalization is the natural outcome of a financial

development process, and that, consistent with many endogenous growth theories, it is

financial development that leads to increased growth. When Bekaert, Harvey and

Lundblad (2002c) add a number of banking and stock market development indicators to

their regressions, the liberalization effect is reduced only marginally in most specifications

but more substantially in a specification excluding the poorest countries. Moreover, they

find that financial liberalization predicts additional financial development, but that the

decision to liberalize does not seem to be affected by the degree of financial development.

Hence, it is likely that one channel through which financial liberalization increases growth

is by its impact on financial development.15

4.3.4. Functional capital markets

A final possibility acknowledges the imperfection of capital markets, which drives a

wedge between the cost of internal and external capital and makes investment sensitive to

the presence of internally generated cash flows. Foreigners may demand better corporate

governance and financial liberalization, then, may coincide with security law reforms that

enforce better corporate governance. Improved corporate governance may lead to lower

costs of capital and increased investment (see Dahlquist et al., 2002). To capture this,

Bekaert, Harvey and Lundblad (2002c) use a variable constructed by Bhattacharya and

Daouk (2002), who trace the implementation and enforcement of insider trading laws in a

large number of countries. Bekaert, Harvey and Lundblad (2003a) find that the enforce-

ment of insider trading laws has a positive effect on growth and is statistically significant

in three of their four samples. Importantly, it does not diminish the impact of financial

liberalizations on economic growth. Another reason to suspect that corporate governance

matters for growth prospects is that Bekaert, Harvey and Lundblad (2001) find larger

liberalization effects for countries with an Anglo-Saxon legal system, which are thought to

have better corporate governance systems (see Shleifer and Vishny, 1997). On a more

basic level, it appears that more secure property rights lead to better capital accumulation

and higher growth (see Claessens and Laeven, 2003).

4.4. Other real effects of financial liberalization

The positive growth effects are very surprising from the perspective of a large literature

focusing on the detrimental effects of financial liberalization. Fig. 9 is taken from a World

Bank document on private capital flows to emerging markets. The consensus view is

simple. Financial integration naturally leads to increased capital inflows. This, in turn,

increases asset prices (either rationally or irrationally), improves liquidity, and triggers a

rapid expansion in bank credit. The lending boom then leads to a consumption binge, and

potentially a real estate bubble. Apart from the appreciation in asset prices, the real

exchange rate appreciates as well, aggravating macroeconomic vulnerability. A weak and

inadequately regulated banking sector may aggravate this process by lending for spec-

15 See Beck et al. (2000a,b), Demirguc�-Kunt and Levine (1996), Demirguc�-Kunt and Maksimovic (1996) and

Rajan and Zingales (2001), for work on financial development and growth.



ulative purposes, consumption and frivolous investments, including the fuelling of a

construction boom. When inflated assets are used as collateral to justify further borrowing,

a boom–bust cycle is clearly in the making. The consensus view appears to be that

liberalization dramatically increases financial sector vulnerability in many countries and

that a weak banking sector played a large role in both the Mexican and Asian crises.

While this interpretation of how foreign capital can wreak havoc in the real economy of

developing countries is widely accepted, it is surprising that empirical evidence for this

view is very scarce. Bekaert, and Harvey (2000b) conduct a very simple exercise. First,

they find the date at which foreign investors may have become marginal investors in the

local equity market by using structural break tests applied to empirical measures of U.S.

holdings of local market capitalization (see also, above). Second, they test for changes in a

number of real variables, finding a larger trade sector, less long-term country debt, lower

inflation and lower foreign exchange volatility. They also test whether the real exchange

rate appreciates after the equity flow breaks and find that it does in 9 of 16 countries.

However, there is a significant depreciation in four countries. Overall, panel estimates

reveal a real appreciation of 5–10% that is statistically significant in about half of the

specifications. Hence, the empirical evidence for the real appreciation story is not as strong

as typically believed.

Finally, there is a clear sense that increased volatility in financial markets post

liberalization (for which the empirical evidence is tenuous) also translates into real

variability. Bekaert, Harvey and Lundblad (2002d) test this prediction directly. Investigat-

ing a large cross-section of liberalized and segmented markets and using information

before and after liberalization for a large number of emerging market economies, they

establish that the volatility of consumption and GDP growth did not significantly increase

post-liberalization. When they focus on the years preceding the recent Asian crisis,

volatility actually decreases, which is especially true for the volatility of consumption

Fig. 9. Capital inflows can lead to a vicious circle that increases economic vulnerabilities. Source: World Bank

(1997).



growth. When they include the crises years (1997–2000) and focus on a subset of

developing economies, this strong result is weakened. However, even with the crises’

years, in no case does volatility significantly increase.

Bekaert, Harvey and Lundblad also strip out predictable consumption growth and focus

on idiosyncratic consumption growth variability as in Athanasoulis and van Wincoop

(2000, 2001).16 They find that consumption growth volatility mostly significantly

decreases post-liberalization. The analysis indicates that the drop in idiosyncratic volatility

is economically large. The assertion that globalization has gone too far for emerging

economies is not supported by their empirical analysis. Nevertheless, the crises that did

occur do suggest that financial integration is best accompanied by vigorous reforms of the

domestic financial sector.

5. Contagion

5.1. Currency crises and contagion

In the mid to late 1990s, a number of emerging markets experienced spectacular

currency crises, first Mexico in 1994 (the ‘‘Tequila Crisis’’), then Southeast Asia in 1997

(the ‘‘Asian Flu’’ crisis), and Russia in 1998 (the ‘‘Russian Virus’’ crisis). These crises not

only rejuvenated research on speculative currency attacks, but also created a new

buzzword: ‘‘contagion’’. We divide this literature roughly into two components. First,

there is the work that explores why crises occur in the first place. Second, there is a large

body of work on why crises spread. The literature is too vast to cover here adequately. For

many more references, we refer to the survey articles of Claessens et al. (2001), Claessens

and Forbes (2001), De Bandt and Hartmann (2000) and Krugman (2001). Of course, some

articles examine both what causes currency crises and how they spread across countries.

5.1.1. Predictable currency crises?

There are two main explanations for why a currency may experience speculative

pressures that can lead to a crisis and devaluation (or the floating of the currency).

The first explanation, building on the seminal work of Krugman (1979) and Flood and

Garber (1984), simply argues that if governments follow policies inconsistent with the

currency peg, a speculative attack is unavoidable. Speculators will sell the local currency

and buy foreign currency. The central bank will lose foreign reserves defending the peg

until a critical level of low reserves is reached, at which point the central bank will give up.

Whereas initial models focused on expansionary fiscal policies, expansionary monetary

policies can also lead to speculative attacks. Of course, this model has the strong

implication that speculative attacks should be partially predictable. In fact, growing

budget deficits, fast money growth and rising wages and prices should precede speculative

attacks. If prices rise while the nominal exchange rate remains unchanged, the real

exchange rate will appreciate. Hence, real exchange rate over-valuations should also signal

an imminent crisis. The combination of budget deficits and real exchange rate over-

16 Lewis (1996, 2000) provides an analysis of risk sharing in developed markets.



valuation may also lead to excessive current account deficits. Consequently, if Krugman is

correct, speculative pressures should be predictable from economic data.

The second explanation recognizes that, sometimes, speculative attacks seem to come

out of the blue. That is, the crises are self-fulfilling, caused by ‘‘animal spirits’’, as Keynes

once phrased it. A significant group of investors simply starts speculating against the

currency, provoking a large capital outflow that leads to the eventual collapse of the

exchange rate, thereby validating the negative expectations regarding the survival chances

of the peg. The authorities have no choice but to change their policies and accept the

devalued currency, even though there are ex ante no fundamental reasons for dropping the

peg.17 The empirical prediction of these models is very strong, in that a currency crisis is

essentially unpredictable; government policies will only become expansionary after the

currency has been attacked and devalued.

More recent contributions to this literature [see Ozkan and Sutherland, 1998; Bensaid

and Jeanne, 1997] introduce interaction with fundamental variables in this class of models.

Basically, a deterioration of fundamentals (for instance in unemployment) may make

defending the currency more costly (for instance, by raising interest rates) eventually

leading to a crisis. However, the actual occurrence and timing of the crisis is still

determined by the animal spirits of speculators.

Krugman (2001) distinguishes third-generation models in which currency crises lead to

severe short-term real output declines. Inspired by the Asian crisis, these models may

stress moral hazard driven excessive investment (Corsetti et al., 1999) or bank runs in a

fragile banking system (Chang and Velasco, 2001) as the source of an eventual exchange

rate collapse.

Because we have competing theories, with different empirical predictions, it would be

nice if the data would provide a clear indication of which theory is correct, and definitively

establish whether devaluations are predictable or not. Unfortunately, this is not the case.

Although there have been many empirical studies, they differ in the countries and sample

periods covered, as well as in the questions addressed. For example, it may be that a

currency experiences speculative pressure but that the government successfully defends

the currency and that no devaluation occurs. Some studies focus on predicting this kind of

speculative pressure, (see, e.g. Eichengreen et al., 1995). One could also distinguish

between actual devaluations, and regime transitions, like flotations.

Overall, there appear to be macro-economic signals that predict currency crises.

Eichengreen et al. focusing on devaluations in OECD (developed) countries, find that

monetary factors, current account deficits and inflation matter, but fiscal deficits do not

matter. Past crises matter for current ones indicating that credibility is important. Esquivel

and Larrain (2000) include also developing countries in their sample and find that real

exchange rate misalignment, high monetary growth rates, low foreign exchange reserves

and current account imbalances predict currency crises.

17 Technically, such self-fulfilling attacks are possible in models with multiple equilibriums. There is a stable

equilibrium, in which the government follows the right policies consistent with the peg, but there is also another

equilibrium in which speculators attack the currency and the government accommodates the lower exchange rate,

see, for example, Obstfeld (1986) or Masson (1999). Drazen (1998) provides a different approach in studying

political contagion.



Klein and Marion (1997) and Goldfajn and Valdes (1997) also confirm that real

exchange rate over-valuation is an important factor in predicting currency crises.

Kaminsky et al. (1998) claim that a currency crisis is imminent when variables such as

exports, output, the money/international reserves ratio and equity prices cross threshold

levels. The empirical results therefore, fall some where between the first two models, there

is some but rather weak, predictive power. The evidence on currency crisis predictability

seems inconclusive.

5.1.2. Currency crisis contagion

It is from the perspective of the self-fulfilling attack literature that contagion seems

easiest to understand. This literature defines contagion, in the context of currency crises,

as the effect on the probability of a speculative attack, which stems from attacks on other

currencies (see also De Gregorio and Valdes, 2001). When speculators attack one

currency successfully, they may well try another. However, it is important to realize that

contagion may also be truly rational and, perhaps, predictable, for a variety of reasons. For

example, trade is a strong linkage between countries that has an obvious currency

component (see Gerlach and Smets, 1994). When the British pound leaves the European

Monetary System (EMS) in 1992 and depreciates, but the Irish punt remains in the EMS

and does not devalue, it is likely that the Irish punt experiences a real exchange rate

appreciation relative to the pound (unless inflation rapidly reacts to the changes in

exchange rates, which, in 1992, it did not). Hence, the real exchange rate appreciation

adversely affects the competitive position of Irish exporters, eventually causing economic

and political pressure to devalue. A related channel of apparent contagion is an income

effect—reduced growth and lower income levels after a crisis reduce the demand for

imports from other countries. A third channel is the ‘‘wake up call’’. It may be that the

second country experienced similar negative macroeconomic conditions or followed

similar inconsistent policies.

In addition to these channels, Forbes (2000) analyzes two other channels by which

crises spread: a credit crunch (banks affected by a crisis in one country reduce lending to

other countries) and a forced-portfolio recomposition or liquidity effect (investors that

suffer losses from a crisis in one country sell assets in other countries). Forbes uses data

from over 10,000 firms to test for the relative importance of each of these five channels of

‘‘contagion’’ during the Asian and Russian crises and finds that the first two channels

(based largely on trade) are the most important.

Esquivel and Larrain (2000) document some evidence of regional contagion, in that a

currency is more likely to devalue if a neighboring country has experienced a devaluation

even controlling for other determinants of devaluation. Eichengreen et al. (1996) also find

that contagion is primarily due to trade links. More research seems warranted on the

channels through which contagion may occur.

5.2. Contagion and equity markets

Contagion in equity markets refers to the notion that markets move more closely

together during periods of crisis. A first problem in the literature is then to define what

constitutes a crisis, especially given the extreme volatility of many emerging equity



markets. Consider the simple exercise in Table 5 that details the five most severe negative

returns in 17 emerging markets. In 9 of 17 markets, August 1998 (Russian default) was

among the one of the five poorest performing months. For the Asian Crisis of July 1997 to

May 1998, Indonesia, Korea, Malaysia and Thailand each have four representatives in the

five worst returns during these months. On the other hand, none of the Latin American

countries have any of their five worst return months during the Asian Crisis. Finally, the

Mexican crisis of December 1994 shows up in a large negative return for Mexico.

Interestingly, this month does not appear in any of the other Latin American or Asian

worst return months. It should also be noted that October 1987 which is the date of a sharp

Table 5

The five largest negative log returns

Largest 2nd largest 3rd largest 4th largest 5th largest

Argentina Jul-89 Jan-90 Apr-81 Apr-84 Jan-82

� 104.8% � 77.6% � 59.8% � 52.7% � 46.2%

Brazil Mar-90 Jun-89 Aug-98 Jun-92 Jan-99

� 84.2% � 56.3% �� 46.7% � 36.7% � 34.5%

Chile Jan-83 Aug-98 Sep-81 Oct-87 Sep-84

� 32.9% �� 30.9% � 21.2% � 21.2% � 18.6%

Colombia Aug-98 Jan-99 Feb-92 Jun-99 May-00

�� 22.2% � 20.5% � 19.2% � 19.0% � 15.2%

Greece Jan-88 Aug-98 Jan-83 Oct-92 Oct-85

� 36.8% �� 27.6% � 20.5% � 18.9% � 18.5%

India May-92 Mar-93 Mar-01 Nov-86 Sep-01

� 27.9% � 19.6% � 19.0% � 17.6% � 16.6%

Indonesia Aug-97 May-98 Dec-97 Jan-98 Sep-98

�� 51.2% �� 49.0% �� 44.8% �� 43.0% � 27.6%

Korea Dec-97 Oct-97 Nov-97 May-98 Oct-00

�� 40.9% �� 35.3% �� 32.7% �� 26.4% � 23.3%

Malaysia Aug-97 Oct-87 Aug-98 Nov-97 Jun-98

�� 37.4% � 36.5% �� 30.9% �� 27.2% �� 24.4%

Mexico Nov-87 Dec-82 Oct-87 Dec-94 Aug-98

� 89.9% � 62.8% � 55.3% �� 43.1% �� 41.0%

Pakistan May-98 Oct-98 Jun-98 May-00 Jul-96

� 43.3% � 30.8% � 29.1% � 24.3% � 17.5%

Philippines Sep-90 Aug-98 Aug-97 Sep-87 Oct-00

� 34.7% �� 31.9% �� 28.2% � 27.5% � 22.1%

Portugal Nov-87 Dec-87 Oct-87 Feb-88 Oct-92

� 34.7% � 27.8% � 23.2% � 16.0% � 15.3%

Taiwan Oct-87 Aug-90 Jun-90 Oct-88 Dec-88

� 43.9% � 41.8% � 30.7% � 28.8% � 28.7%

Thailand Oct-87 Aug-97 Oct-97 May-98 Dec-97

� 41.3% �� 39.3% �� 38.1% �� 33.1% �� 29.1%

Turkey Aug-98 Feb-01 Nov-00 Sep-01 Nov-90

�� 52.2% � 52.0% � 43.2% � 40.6% � 37.8%

Venezuela Dec-85 Nov-95 Aug-98 Mar-92 Jun-94

� 68.9% � 62.0% �� 50.5% � 30.3% � 29.2%

Composite Aug-98 Oct-87 Aug-90 Sep-01 Oct-97

�� 29.3% � 28.9% � 19.0% � 16.8% �� 16.5%

Bolded dates and log returns represent crisis periods.



drop in the U.S. stock market, shows up in the list for Mexico, Portugal, Taiwan and

Thailand.18

The analysis in Table 5 is related to the recent work of Bae et al. (in press) who, using

daily returns data in a number of emerging markets, look for the coincidences of extreme

movements. Interestingly, they attempt to characterize (predict) the degree of coincidence

using fundamental economic variables such as interest rates, exchange rate changes and

conditional volatility (also see Karolyi and Stulz (1996) and Hartmann et al., 2001). The

coincidence of extreme equity return movements may be one definition of contagion but

Forbes and Rigobon (2002) declare, ‘‘there is no consensus on exactly what constitutes

contagion or how it should be defined.’’ Rigobon (in press) states, ‘‘paradoxically, . . .there is no accordance on what contagion means.’’

Importantly, contagion is not simply increased correlation during a crisis period. From a

completely statistical perspective, one would expect higher correlations during periods of

high volatility.19 Forbes and Rigobon (2002) present a statistical correction for this

conditioning bias and argue that there was no contagion during the three most recent

crises.20

Bekaert, Harvey and Ng (2003b) and Tang (2002) define contagion as excess

correlation—correlation over and above what one would expect from economic funda-

mentals and take an asset pricing perspective to studying contagion. For a given factor

model, increased correlation is expected if the volatility of a factor increases. The size of

the increased correlation will depend on the factor loadings. Contagion, therefore, is

simply defined by the correlation of the model residuals. Tang restricts the underlying

asset pricing model to a world capital asset pricing model (CAPM) whereas Bekaert et al.

examine a more general factor model.

By defining the factor model, they effectively take a stand on the global, regional and

country specific fundamentals as well as the mechanism that transfers fundamentals into

correlation. Concretely, they apply a two-factor model with time-varying loadings to

‘‘small’’ stock markets in three different regions, Europe, Southeast Asia and Latin

America. The two factors are the U.S. equity market return and a regional equity portfolio

return. Their framework nests three models: a world capital asset pricing model (CAPM), a

world CAPM with the U.S. equity return as the benchmark asset and a regional CAPM

with a regional portfolio as the benchmark. They also add local factors to allow for the

possibility of segmented markets. If the countries in a particular region are globally

integrated for most of the sample period, but suddenly see their intra-regional correlations

rise dramatically during a regional crisis, their contagion test would reject the null

hypothesis of no contagion. On the other hand, if these countries expected returns are

not well described by a global CAPM, but rather by a regional CAPM, the increased

correlations may simply be a consequence of increased factor volatility.

20 As Forbes and Rigobon (2002) note, their methodology only works under a restrictive set of

circumstances. An alternative is the test in Rigobon (in press (a)).

19 See Stambaugh (1995), Boyer et al. (1999), Loretan and English (2000) Forbes and Rigobon (2002) and

early work by Pindyck and Rotemberg (1990, 1993). Work linking news, volatility and correlation includes King

and Wadhwani (1990), Hamao et al. (1990) and King et al. (1994).

18 There is also some evidence that equity markets anticipate some currency crises (see Harvey and Roper,

1999; Becker et al., 2000; Glen, 2002).



Equity return volatilities in the Bekaert, Harvey and Ng (2003b) model follow

univariate generalized autoregressive conditional heteroskedasticity (GARCH) processes

with asymmetry as in Bekaert, and Harvey (1997) and Ng (2000). Hence, negative news

regarding the world or regional market may increase the volatility of the factor more than

positive news and hence lead to increased correlations between stock markets.21 More-

over, their model incorporates time-varying betas where the betas are influenced by trade

patterns as in Chen and Zhang (1997). The results in Bekaert, Harvey and Ng (2003b)

indicate the presence of contagion around the SouthEast Asian crisis, but not during the

Mexican crisis. This contagion is not limited to SouthEast Asian, but extends to Latin

America. These conclusions are broadly consistent with Rigobon (in press (b)) and

Dungey and Martin (2001) who use a different methodology.

Finally, there are a number of recent papers that link contagion to liquidity and financial

frictions (see Calvo, 1999; Calvo and Mendoza, 2000a,b; Kodres and Pritsker, 2002;

Rigobon, 2002b; Yuan, 2002). Kyle and Xiong (2001) show how wealth effects can lead

to contagion.

6. Other important issues

6.1. Corporate finance

Corporations in emerging markets provide an ideal testing ground for some important

theories in corporate finance. For example, Lombardo and Pagano (2000) examine how

legal institutions affect the return on equity. The cross-sectional variation in such

institutions is particularly large for emerging markets. Similarly, it is often argued that

the existence of a sufficient amount of debt helps mitigate the agency problems that arise

as a result of the separation of ownership and control. In a number of emerging markets,

the existence of multilevel ownership provides an environment, where there is an acute

separation of cash flow and voting rights. Given the possibility of severe agency problems,

emerging markets provide an ideal venue to test these theories. That is, powerful tests of

these theories can be conducted in samples that have large variation in agency problems.

In order to compete in world capital markets, a number of countries are grappling with

setting rules or formal laws with respect to corporate governance. There is a growing

realization that inadequate corporate governance mechanisms will increase the cost of

equity capital for emerging market corporations as they find it more difficult to obtain

equity investors.

Overall, research has characterized the degree of external corporate governance in

emerging markets as weak (Johnson et al. (2000b); Denis and Connell, 2002; Klapper and

Love, 2002). Both shareholder rights and the legal enforcement of the rights that do exist

are generally lacking in emerging markets (La Porta et al., 1998), and the use of corporate

21 Longin and Solnik (1995) report an increase in cross-country correlation during volatile periods. Other

empirical studies (for example, Erb et al., 1994; De Santis and Gerard, 1997) find different correlations in up and

down markets while Longin and Solnik (2001), Ang and Bekaert (2002) and Das and Uppal (2001) document

higher correlations in bear markets. Erb et al. (1995) document higher correlations during U.S. recessions.



takeovers as a disciplining mechanism is almost nonexistent. Further, as mentioned above,

it is frequently the case that insiders possess control rights in excess of their proportional

ownership. This is usually achieved through pyramid structures in which one firm is

controlled by another firm, which may itself be controlled by some other entity, and so

forth (Shleifer and Vishny, 1997; La Porta et al., 1998, 1999; Claessens et al., 2000; Lins,

2003). Finally, irrespective of pyramid structures, managers of emerging market firms

sometimes issue and own shares with superior voting rights to achieve control rights that

exceed their cash flow rights in the firm (Nenova, in press; Lins, 2003). Taken together,

the net result is that a great number of firms in emerging markets have managers who

possess control rights that exceed their cash flow rights in the firm, which, fundamentally,

gives rise to potentially extreme managerial agency problems.

When external country-level corporate governance is weak, it is possible that internal

governance in the form of concentrated ownership will step in to fill the void (see

Himmelberg et al., 2002). Lins (2003) investigates whether management ownership

structures and large non-management blockholders are related to firm value across a

sample of 143 firms from 18 emerging markets. He finds that firm values are lower when a

management group’s control rights exceed its cash flow rights. Lins also finds that large

non-management control rights blockholdings are positively related to firm value. Both of

these effects are significantly more pronounced in countries with low shareholder

protection. One interpretation of these results is that, in emerging markets, large non-

management blockholders can act as a partial substitute for missing institutional gover-

nance mechanisms.

Lemmon and Lins (2003) use a sample of 800 firms in eight East Asian emerging

markets to study the effect of ownership structure on value during the region’s financial

crisis. The crisis negatively impacted firms’ investment opportunities, raising the incen-

tives of controlling shareholders to expropriate minority investors. Further, because the

crisis was for the most part unanticipated, it provides a ‘‘natural experiment’’ for the study

of ownership and shareholder value that is less subject to endogeneity concerns. During

the crisis, cumulative stock returns of firms in which managers have high levels of control

rights, but have separated their control and cash flow ownership, are 10 to 20 percentage

points lower than those of other firms. The evidence is consistent with the view that

ownership structure plays an important role in determining the incentives of insiders to

expropriate minority shareholders.

A related issue is the relation between the ownership structure and local authority.

Johnson and Mitton (2003) examine Malaysian firms before and after the imposition of

capital controls and find that firms with stronger ties to Prime Minister Mahatir benefited

from the imposition of the capital controls. They interpret this as evidence that the capital

controls provided a screen behind which favorable firms could be supported, as evidence

of crony capitalism.

Claessens et al. (2003) examine the incidence of bankruptcy filings during the Asian

crisis. They find after controlling for firm characteristics that bank-owned or group-

affiliated firms were much less likely to file for bankruptcy. They also find that those

countries with stronger creditor rights and better judicial systems have increased likelihood

of bankruptcy filings. Johnson et al. (2000a) show that countries with lower quality

corporate governance were hit harder during the Asian crisis.



Gibson (2000) examines the relation between CEO turnover and firm performance in

emerging markets. In general, he finds a high turnover after poor performance, which is

consistent with good corporate governance. However, when he isolates firms with a large

domestic shareholder, such as a group-affiliated firm, there is no relation between

performance and CEO turnover. This suggests that these ownership structures impede

good corporate governance in emerging markets.

Lins and Servaes (2002) use a sample of over 1000 firms from seven emerging markets

to study the effect of corporate diversification on firm value. They find that diversified

firms trade at a discount of approximately 7% to single-segment firms. From a corporate

governance perspective, Lins and Servaes find a discount only for those firms that are part

of industrial groups, and for diversified firms with management ownership concentration

between 10% and 30%. Further, the discount is most severe when management control

rights substantially exceed management cash flow rights. Their results do not support

internal capital market efficiency in economies with severe capital market imperfections.

Since management control and a separation of management ownership and control are

associated with lower firm value in emerging markets, a question arises as to whether

alternative external firm-level governance mechanisms exist that might improve the

situation for minority shareholders. Several alternate governance mechanisms have the

potential to lessen real or perceived agency problems between a firm’s controlling

shareholders and managers and its minority shareholders. Harvey et al. (2002) examine

whether debt contracts can alleviate problems with potentially misaligned incentives that

result when managers of emerging market firms have control rights in excess of their

proportional ownership. Harvey et al. provide evidence that higher debt levels lessen the

loss in value attributed to these managerial agency problems. When the authors investigate

specific debt issues, they find that internationally syndicated term loans, which arguably

provide the highest degree of firm-level monitoring, enhance value the most when issued

by firms with high levels of expected managerial agency problems.22

Another potential firm-level governance mechanism that has received considerable

research attention is a firm’s decision to issue a cross-listed security, such as an (ADR). For

firms in emerging markets and those with poor external governance environments, this

allows the firm to ‘‘opt in’’ to a better external governance regime and to commit to a

higher level of disclosure, both of which should increase shareholder value. Along this line

of reasoning, Doidge et al. (2002) present evidence that non-U.S. firms with exchange-

listed ADRs have higher Tobin’s Q values and that this effect is most pronounced for firms

from countries with the worst investor rights. Lang et al. (2002a) find that firms from

emerging markets or non-English legal origin countries that have -listed ADRs show a

greater improvement in their information environment (as measured by stock market

analyst coverage and analyst forecast accuracy) than do developed markets firms with

English legal origins that have exchange-listed ADRs. Lang et al. also show that

22 Booth et al. (2001) find that the choice of debt ratios in emerging markets is more sensitive to country-

specific factors than in developed markets. This is consistent with the existence of greater information

asymmetries in developing markets. Demirguc�-Kunt and Maksimovic (1996) examine the link between firm

financing and stock market development.



improvements in the information environment for firms with listed ADRs are positively

related to firm valuations.

Lins et al. (2001) test directly whether improved access to capital is an important

motivation for emerging market firms to issue an ADR. They find that, following a U.S.

listing, the sensitivity of investment to free cash flow decreases significantly for emerging

market firms, but does not change for developed market firms. Also, emerging market

firms explicitly mention a need for capital in their filing documentation and annual reports

more frequently than do developed market firms, whereas, in the post-ADR period,

emerging market firms tout their liquidity rather than a need for capital access. Further,

Lins et al. find that the increase in access to external capital markets following a U.S.

listing is more pronounced for firms from emerging markets. Overall, these findings

suggest that greater access to external capital markets is an important benefit of the U.S.

stock market listing, especially for emerging market firms.

Research analysts have the potential to increase the scrutiny of controlling management

groups endowed with private benefits of control, which should improve firm values.

Controlling managers have incentives to hide information from the investing public in

order to facilitate consumption of these private control benefits. Lang et al. (2002b) find

that analyst coverage positively impacts Tobin’s Q values and that there is an incremental

valuation benefit to additional analysts coverage when the management/family group

controls a firm. Further, these benefits of analysts’ coverage are significantly more

pronounced for firms from countries with poor shareholder rights and with non-English

origin legal systems.

The private benefits of control are also studied in Dyck and Zingales (2002a). They find

that the private benefits of control are higher when the buyer comes from a country that

protects investors less (and, thus, is more willing or able to extract private benefits). In

countries where private benefits of control are larger capital markets that are less

developed, ownership is more concentrated, and privatizations are less likely to take

place as public offerings. Dyck and Zingales (2002a,b) show that one important

mechanism to minimize the negative impact of the private benefit of control and to

enforce good corporate governance is the local media (as represented by the ratio of

newspaper circulation to total population).

6.2. Fixed income

Emerging market equities have garnered a great deal more research attention than

emerging market bonds. This is probably due to the availability of equity data versus bond

data.23 Although much of the research on emerging market bonds applies only to the last

15 years, global bond investing has a long and storied history. Through the First World

War, London was the center of global finance. Indeed, the U. S. was for much of the 19th

century considered as an emerging market. Not only was it emerging, but it also went

through periodic eras of default. According to Chernow (1990), ‘‘During the depression of

23 A historical analysis of the U.S. as an emerging market is found in Rousseau and Sylla (1999). Rousseau

and Sylla (2001) examine the financial development of a number of countries.



the 1840s—a decade dubbed the Hungry Forties—state debt plunged to 50 cents on the

dollar. The worst came when five American states—Pennsylvania, Mississippi, Indiana,

Arkansas and Michigan—and the Florida Territory defaulted on their interest payments.’’

Latin American lending had already become quite widespread in the 19th century.

Chernow states that ‘‘. . .as early as 1825 nearly every borrower in Latin America had

defaulted on interest payments. In the 19th century, South America was already known for

wild borrowing sprees, followed by waves of default.’’ By the 1920s, foreign lending in

the U. S. had once again become widespread. In fact, the sale of repackaged foreign bonds

to individual investors, and the subsequent losses, was an impetus to the pasage of the

Glass-Steagall Act in 1933, (see Chernow, 1990).

Erb et al. (2000) provide a historical analysis of emerging market bonds, using data

from 1859 for Argentina, Brazil and the U.S. They find a similar level of volatility in

emerging market bond and equity returns. Indeed, their correlation analysis (using more

recent data) suggests that the correlation between emerging market bond returns and

emerging market equity returns is over 0.70. Perhaps this is not surprising. Emerging

market bonds are high-risk bonds, and often these types of bonds act like equity.

Considerable theoretical and empirical research has focused on understanding sover-

eign yield spreads (the spread between foreign government bond yields denominated in

U.S. dollars and a similar maturity U.S. Treasury bond). The first branch of research tries

to capture the strategic aspects of when a country should borrow and default (see Eaton

and Gersovitz, 1981; Bulow and Rogoff, 1989a,b; Chowdhry, 1991). For example, the

Bulow and Rogoff (1989b) model suggest that the threat of political and economic

sanctions enforces the debt contracts between developing and developed nations. How-

ever, these models do not take a stand on what the sovereign credit spread should be. A

second branch of research is cast in continuous-time, and focus on the likelihood of default

and the determination of credit spreads in particular countries (see Kuilatilaka and Marcus,

1987; Claessens and Pennachi, 1996; Gibson and Sundaresan, 2001; Duffie et al., 2003).

Gibson and Sundaresan derive a relation between sovereign yield spreads and the cost of

sanctions. They show that the ability to punish the sovereign borrower leads to a lower

sovereign spread. Duffie et al. show how to incorporate default, restructuring as well as

illiquidity into a model of sovereign yield spreads. The final branch of research examines

the cross-sectional relationship between fundamental variables in the economy and the size

of the sovereign spreads (see Eichengreen and Mody, 2000; Cantor and Packer, 1996; Erb

et al., 1997) For example, Erb et al. show that country risk ratings are positively associated

with real per capita GDP, real per capita GDP growth, and the investment to GDP ratio.

They find that ratings are negatively related to population growth. Given the strong

negative correlation between ratings and sovereign spreads, these models provide a way to

link the fundamental characteristics of an economy to the sovereign spread.

6.3. Market microstructure

The particular trading arrangements in an equity market may directly affect two key

functions of that counytry’s secondary stock market: price discovery, and liquidity. First,

the trading process should lead to ‘‘fair’’ and correct prices; in other words, no investor

should be able to manipulate market prices in his or her favor. Second, trading should



occur at a, low transaction cost, high speed, and large quantities should trade without

affecting the price. These issues are the topic of the field of market microstructure. It is

clear that the large cross-sectional heterogeneity of emerging markets and the formidable

changes they have undergone over time should make them an interesting laboratory for

market microstructure research.

While a number of academics have looked at the issue of market segmentation using

detailed data from one country (see, for example, Domowitz et al., 1997; Bailey and

Chung, 1995 for Mexico, and Bailey and Jagtiani, 1994 for Thailand), there is surprisingly

little genuine microstructure research on emerging markets, perhaps because accurate and

detailed data are difficult to obtain. There are a few exceptions though, which we now

discuss.

Domowitz et al. (1998) use detailed data on Mexican stocks to investigate whether the

cross-listing of securities, although beneficial from a market integration perspective, may

lead to order flow migration to the more liquid international (often US) market. Cho et al.

(2003) use the Taiwanese market, with its unique price limits, to test the well-known

magnet effect. The magnet effect postulates that prices accelerate towards the limits when

getting closer to them. Cho et al. find strong evidence of a magnet, effect especially for the

ceiling price.

Eventually, microstructure research is especially interested in transaction costs and

liquidity, which differ greatly across emerging markets (see Glen, 2000 for an introduction

to microstructure in emerging markets). Ghysels and Cherkaoui (2003) provide a detailed

study of the Casablanca Stock Exchange in Morocco (CSE). The CSE is a typical

emerging financial market that has gone through momentous change in the last 10 years.

In the 1980s, the CSE in many ways a backwater. It was a state institution, on which very

few stocks were listed and with almost no participation of individual investors. Institu-

tional investors would often trade on the large ‘‘upstairs’’. The upstairs market was a

negotiated market where trades were based on mutual agreements, and where transactions

were established under circumstances that were neither transparent nor standardized.

During this period, the number of Moroccan shareholders was probably less than 10,000.

The exchange was extremely illiquid and most stocks did not trade for weeks. In 1989,

Morocco announced an ambitious privatization and economic liberalization program,

which also included financial market reforms that would greatly alter the operation of the

stock exchange starting in 1993. The CSE was both privatized and reformed. The market

reforms created a dealer/market maker structure under which more disclosure was required

from both listing companies and market makers. Whereas Morocco never prevented

foreign investors from buying Moroccan stock, CSE’s pre-reform the archaic structure and

low trading volume effectively kept foreigners from participating in the market. The new

reforms changed this, and in 1996, the CSE was included in the IFC Emerging Market

database. Even before then, the number of individual investors had increased considerably,

reaching 300,000 in 1996. These reforms had a profound effect on the stock market.

Trading volume and liquidity exploded. Finally, on December 17, 1996, the CSE adopted

the screen-driven trading system used by the Bourse de Paris.

It is generally believed that such microstructural changes should greatly affect the

quality of the market, which can best be approximated by the cost of trading. There is no

doubt that reforms immediately increased turnover and liquidity in the Moroccan Market,



but did that also mean lower trading costs for the average trader on the market?

Unfortunately, we do not have bid-ask spread data for the CSE. However, Ghysels and

Cherkaoui (2003) obtained transactions data before and after the reforms for several

stocks, and tried to infer the trading costs based on these data. Surprisingly, they find that,

at least up until 1996, trading costs increased after the reforms. There are multiple

interpretations of these results. First, on an absolute basis, although liquidity improved,

the CSE remained a very thin, illiquid market with little trading. Second, foreign in-

vestors (especially new arrivals) may be among the least informed market participants.

Possibly, CSE dealers possessed a tremendous amount of market power relative to

foreign traders. This would imply that the high spreads were not a competitive

equilibrium phenomenon, but rather indicated a fleecing opportunity, which disappeared,

as foreign investors became more informed and the market developed. A third possibility

is that the model used by Ghysels and Cherkaoui mis-estimates true trading costs. On the

other hand, if the results are accurate a few important lessons may be drawn from this

detailed study. First, jumps in turnover and trading need not necessarily be associated

with lower trading costs (although they typically are). Second, microstructure reforms

may be an important signal to foreign investors of the local stock exchange’s genuine

integration into the world financial markets. However, by themselves, such reforms do

not seem to contribute to bringing down the effective costs of trading. Only after screen-

driven trading was introduced in late 1996 did transaction costs CSE fall (see Derrabi et

al., 2000).

Obtaining estimates of liquidity and transaction costs is important because: illiquid

assets and assets with high transaction costs trade at low prices, relative to their expected

cash flows. It follows that liquidity and trading costs may contribute both to the average

equity premium in stocks and to the time-variation in expected returns if there is

systematic variation in liquidity. Some recent research, most notably Amihud (2002)

and Jones (2001), attempts to quantify the role of liquidity in U.S. expected stock returns.

Using 100 years of annual data, Jones finds that bid-ask spreads and turnover predict U.S.

stock returns one period ahead, whereas the decline in transaction costs may have

contributed to a fall of about 1% in the equity premium. Amihud (2002), using a

1964–1997 NYSE sample, finds that expected market illiquidity has a positive effect

on the ex ante excess return and unexpected illiquidity has a negative effect on the

contemporaneous stock return.

Liquidity effects may be particularly acute in emerging markets. In a survey by Chuhan

(1992), poor liquidity was mentioned as one of the main reasons for foreign institutional

investors not investing in emerging markets. If the liquidity premium is an important

feature of the data, emerging markets should yield particularly powerful tests and useful

independent evidence. Moreover, the recent equity market liberalizations provide an

additional verification of the importance of liquidity for expected returns, since, all else

equal (including the price of liquidity risk), the importance of liquidity for expected returns

should decline post liberalization. This is important, since when focusing on the U.S.

alone, the finding of expected return variation due to liquidity can always be ascribed to an

omitted variable correlated with liquidity. Another important question is whether improved

liquidity contributes to the decline in the cost of capital post-liberalization which is

documented by Bekaert and Harvey (2000a) and Henry (2000a).



Bekaert, Harvey and Lundblad (2002e) address these questions in a recent article using a

measure that relies on the incidence of observed zero daily returns in these markets.

Lesmond et al. (1999) and Lesmond (2002) argue that if the value of an information signal is

insufficient to outweigh associated transaction costs, market participants will elect not to

trade, resulting in an observed zero return. They propose zero returns as evidence of

transaction costs. Using a simple empirical pricing model and limited dependent variable

estimation techniques, they infer estimates of transaction and price impact costs. Lesmond

(2002) applies this indirect approach to estimate the costs of equity trading in emerging

markets. The advantage of this measure is that it requires only a time-series of daily equity

returns.

Bekaert, Harvey and Lundblad (2002e) use the zero return measure as a proxy for

illiquidity. They find that higher illiquidity is indeed associated with higher expected

returns. Whereas liberalization overall improves liquidity, its effect on the relation between

illiquidity and expected returns is somewhat inconsistent. However, it is invariably the

case that the effect of illiquidity on expected returns is larger post-liberalization.

6.4. Stock selection

Most work on emerging market stock returns has focused on the IFC global index of

IFC investible indices. However, there are a few papers that examine the characteristics of

individual securities.

Stock selection is complicated by potentially extreme information asymmetry prob-

lems. Bhattacharya et al. (2000) provide evidence that Mexican stocks do not react

contemporaneously to the usual types of news announcements. However, they find that the

stocks react before such announcements, which is consistent with information leakage. In

addition, they find that the price reaction of shares traded by foreigners lag those traded by

nationals. This is consistent with information asymmetry.24

Fama and French (1998) collect information on size, book to market value, and price

earnings ratios for 16 emerging markets. They find strong evidence of a value premium in

these markets in both in-sample and out-of-sample tests. Rouwenhorst (1999) examines

the characteristics of over 1700 firms in 20 emerging markets and finds that the cross-

section of stock returns in emerging markets is driven by factors that also drive the cross-

section in developed markets: size, momentum, and value.

Achour et al. (1999) examine a comprehensive list of 27 firm-specific factors to try to

explain the cross-section of returns in three representative emerging markets. In contrast to

previous work, Achour et al. examine both ex post and expectational firm characteristics.

They find that measures, such as prospective earnings to price ratios, and analyst revision

ratios, can differentiate between high and low expected return securities. While they

document that some characteristics impact each market, there are considerable asymme-

tries across different markets. In addition, Achour et al. show that traditional measures of

risk are unable to account for the differences in expected returns.

Van Der Hart et al. (2003) provide the most comprehensive analysis of individual stock

returns in emerging markets by studying almost 3000 securities in 32 countries. Similar to

24 Also see Choe et al. (2002) and Frankel and Schmukler (2000).



Achour et al. (1999), Van Der Hart et al. look at both ex post and expectational

characteristics. They confirm the profitability of strategies based on value and momentum

and show that the returns cannot be explained with traditional asset pricing models. In

contrast to previous work, Van Der Hart et al. examine the ability to implement these

strategies. They show that the profitability of these strategies is robust to the assumed

transactions cost of a large institutional investor.

6.5. Privatization

In most emerging markets, privatization was intended to increase the productivity of

state-owned economic enterprises (SOEs), and to help reduce government budget deficits.

In some cases, governments actively sought to promote capital market development

through privatization. Many governments intended to create a class of people with a stake

in the new economy, therby making it more difficult for political changes to be reversed.

Regardless of the goal, privatization was not initiated, in order to divest fully the

government’s interest in the real economy. Nevertheless, even the partial divestment

under consideration was economically substantial.

Consider the evidence presented in Table 6. Between 1978 and 1991, SOEs in

emerging markets controlled a significant proportion of (GDP). In our sample of 16

Table 6

The role of state-owned enterprises in emerging economies (1978–1991)

Country SOE economic

activity as % of

GDP (1978–1991)a

Trade as % of

GDP (1978–1991)bStock market

capitalization as % of

GDP (1978–1991)c

Argentina 4.7 15.4 1.8

Brazil 6.5 15.7 3.0

Chile 13.3 42.6 15.6

China n.a. n.a. n.a.

Colombia 6.8 24.7 2.5

India 12.1 12.6 2.3

Indonesia 14.8 38.9 5.0

Jordan n.a. 72.9 25.5

Malaysia 17.0 129.1 51.0

Mexico 11.6 21.5 4.3

Pakistan 10.3 29.4 2.5

Philippines 1.9 39.9 7.7

Portugal 18.2 53.0 8.4

Thailand 5.4 49.6 6.3

Turkey 7.5 22.2 3.5

Venezuela 23.1 40.9 4.0

Latin American average 11.0 26.8 5.2

Asian average 9.9 46.0 11.2

Average 10.9 40.6 9.6

United Statesa 1.2

a Bureaucrats in Business: The Economics and Politics of Government Ownership (1995).b Time series average of data available from World Development Indicators 1999 CDROM.c Time series average of data available from IFC Emerging Markets Database. Sample size dependent upon

data availability.



emerging economies, SOEs contributed to 10.9% of GDP during this time period. SOEs

in developed economies contributed significantly less, 7.8%. Individual countries

displayed significant cross-sectional variation in terms of the size of each country’s

SOE economic activity as a percent of GDP. For example, in the Philippines this figure

was quite low, averaging 1.9% over the 14-year period. At the other extreme, SOEs in

Venezuela contributed to just over 23% of GDP during the same period. Regardless of

the country in question, the transfer of resources considered under any privatization

program amounts to a non-trivial proportion of the wealth of the economy. Despite its

importance, we provide only a short summary of the vast research on the topic because

there already exists an extensive and excellent survey see Megginson and Netter

(2001).

Privatization programs impact emerging capital markets through various mechanisms.

For instance, share issued privatizations (SIPs) increase the market capitalization and the

value traded on local exchanges. Moreover, SIPs can change the investment opportunity

set of portfolio investors. Public offers of SOEs whose cash flows are not perfectly

correlated with pre-existing companies help investors to achieve gains through diversifi-

cation. Under this scenario, SIPs may help to lower the risk premium investors require for

holding the market portfolio of publicly traded equity.

Other methods of privatization, including the direct sale of former SOEs, the direct sale

of an SOE assets, or concessions of public sector monopolies, alter the dynamics of local

capital markets in less obvious ways. Consider the direct sale of an SOE to a private

investor. This sale does not increase the market capitalization or value traded on the local

exchange. However, the sale may alter the real investment opportunity set of the private

investor.

As viewed from this perspective, all forms of privatization can impact local capital

market dynamics. The common component of privatization that impacts capital markets is

the transfer of productive resources from the public sector to the private sector. This

transfer may allow investors to achieve benefits through diversification and may effect the

cost of capital in emerging markets.

Even if private investors do not benefit from the transfer of resources, i.e. their

investment opportunity set does not change, privatization programs may still influence

capital markets. Privatization programs can help the government signal its commitment to

free market policies (see also Perotti, 1995; Biais and Perotti, 2002). For most emerging

market governments, the implementation of a privatization program reverses decades of

state-led economic development. Successful privatization of politically sensitive industries

may convince investors to reduce the ex ante perceived risk of government interference in

investment decisions and expropriation of productive assets. As a result of sustained

privatization efforts, the sovereign risk premium inherent in the governments fixed income

liabilities may be reduced. As this chain of events ripples through the economy, local

market entrepreneurs eventually benefit in their ability to obtain debt financing at lower

cost.

Bekaert, Harvey and Roper (2002f) find that the privatization of SOEs has increased

local stock market capitalization and the value traded on these exchanges. They also find

that privatization leads to a reduction in the dividend yield, which likely indicates a

reduction in the cost of capital.



7. Conclusion

Most of our research on emerging equity markets has tried to draw inferences from a

somewhat reluctant data set. Emerging market returns are highly non-normal (see Bekaert,

Erb, Harvey and Viskanta, 1998; Susmel, 2001) and highly volatile, and the samples are

short. Moreover, a dominating characteristic of the data is a potentially gradual, structural

break. Although it is generally difficult to make inferences in such a setting, a few robust

findings emerge: the liberalization process has led to a very small increase in correlations

with the world market and a small decrease in dividend yields. This decrease could represent

a decrease in the cost of capital or an improvement in growth opportunities; Bekaert, Harvey

and Lundblad (2001, 2002c) find that economic growth increases post liberalization by

about 1% per year on average over a 5-year period. Bekaert and Harvey (2000a), Henry

(2000a), and Bekaert, Harvey and Lundblad (2002c) all find that aggregate investment

increases significantly after liberalizations, providing one channel for this increased growth.

Das and Mohapatra (2003) not only confirm the growth effect, but also investigate whether

and how the reforms shifted the income distribution. They find an upward shift in the

income share accruing to the top quintile of the income distribution at the expense of the

middle class. The lowest income share remained unchanged. Such research counsels against

drawing hasty inferences between economic growth and economic welfare.

Moreover, with a number of recent crises in emerging markets, the role of foreign

capital in developing countries is again under intense scrutiny. Malaysia temporarily

re-imposed capital controls, which deemed successful by some (see Kaplan and Rodrik,

2002). Thus, it is remarkable that we have so far failed to find negative effects of foreign

investment on emerging markets. For example, although policy makers often complain

about foreigners inducing excess volatility in local markets, our empirical tests never

reveal a robust increase in volatility after liberalization. In other works, we cannot confirm

the often-heard argument that foreign capital consistently drives up real exchange rates.

We cannot even find increased real variability, that is, evidence of the variability of GDP

and consumption growth rates increasing post liberalization (see Bekaert, Harvey and

Lundblad). Despite very real problems in the financial and corporate sectors of the crisis

countries in Southeast Asia, the current literature on the effects of capital flows on

emerging markets reveals little reason for rich developed countries to discontinue their

financing of emerging market country development. After all, one potential reason for the

disappointingly small effect of the cost of capital that Bekaert, and Harvey (2000a) find,

may be a combination of ‘‘segmentation risk’’—foreign investors anticipating future

policy reversals of foreign investment restrictions—and ‘‘home bias’’. ‘‘Home bias’’ refers

to the fact that investors across the world have fairly small proportions of their assets

allocated to foreign markets, and the proportion allocated to emerging markets is

miniscule.25 Portes and Rey (2002) find that the most important determinant of global

equity transactions between two countries is geographical proximity.26 We cannot help but

wonder whether a world blessed with a vast pool of private, internationally active,

25 See Lewis (1999) for a survey of the vast literature on this topic.26 Also see Ahearne et al. (in press).


COLUMBIA BUSINESS SCHOOL 43COLUMBIA BUSINESS SCHOOL 43

speculative capital would have faced the kind of liquidity crises we have seen in recent

years, and in the wake of these crisis the many proposals to limit capital flows.

There remain a number of important caveats, however. Most of our research has

focused on equity market liberalization. Few dispute the beneficial effects of foreign direct

investment (see Borensztein et al., 1998), and most of the work critical of foreign capital

flows focuses on the banking sector and short-term bond flows (see, e.g. Kaminsky and

Reinhart, 1999, 2000). For example, liberalizing debt flows in a weak institutional

environment, including a poorly developed and supervised banking sector, may have

negative consequences. Portfolio equity flows are somewhere in between and seem to

have beneficial effects. Contrasting the real effects of equity market liberalizations and

banking sector liberalizations appears to be an important topic for future research.27 This,

then, also naturally leads back to an old international economics and developmental

economics question (see Edwards, 1987): what is the optimal sequencing of economic and

financial liberalizations in developing countries?

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